Managing foreign exchange risk in times of high volatility

All currencies are prone to periods of high volatility. But the COVID-19 pandemic has caused foreign currency markets to experience levels of volatility that we haven’t seen since the Global Financial Crisis in 2008. 

Businesses that rely on importing or exporting goods have a hard time dealing with volatile periods, and recovering from them as well. Highly volatile periods can result in businesses shutting their doors entirely. However, putting the right measures in place can minimize that risk.

What is foreign exchange risk?

Foreign exchange risk is the risk imposed on the financial performance of a business by currency exchange rate changes. Fluctuating exchange rates have the potential to negatively impact margins and damage a business’s profitability.

Sources of foreign exchange risk

The potential for foreign exchange risk is present in any situation where a business is using a foreign currency. However, businesses that deal with more than one currency are especially prone to risk.

Foreign exchange risks come from:

• Receiving income (interest, dividends, royalties, etc.) and revenue in a foreign currency

• Making payments to suppliers in a foreign currency 

• Receiving business loans in a foreign currency

• Holding offshore assets, such as international business subsidiaries

The danger for businesses

There are a number of ways that volatile foreign exchange can impact your business. Here are a few examples:

• A falling domestic exchange rate often increases import costs. Your profitability as an importer will suffer as a result. For example, if you are a US business importing from Australia, a falling USD is harmful to your business. 

• A falling exchange rate makes product pricing more competitive, and as a result, you’ll benefit as an exporter. Alternatively, a rising exchange rate is harmful to your product pricing.

• Rising domestic exchange rates give importers a more competitive edge over your products if you’re a local producer. You might even lose business to overseas producers.

There are a number of proven strategies that enable effective hedging against foreign exchange risk, since no business wants to deal with exchange rates. 

Managing foreign exchange risk

Spot transactions

Spot transactions — also known as spot contracts — are often the easiest method of managing foreign investment risk. A spot transaction is a single foreign exchange transaction that involves purchasing and settling the amount “on the spot,” usually meaning within two business days. 

Spot transactions require little notice time and have a shorter window for risk. You can book your transaction in a converted currency if you’re happy with the current foreign exchange (FX) rate, but there’s always a chance that you’ll forego a better rate in the future. Booking an immediate spot transaction minimizes the risk of future volatility in your desired foreign currency.

A Forward Exchange Contract (FEC)

An FEC locks down exchange rates at the current price, which allows your business to protect itself from future price fluctuations. An FEC is valid until a specified date of your choice. This contract is beneficial in that you have more control over your profit and won’t actively lose money on your foreign exchange. 

However, it also means you can’t take advantage of more beneficial foreign exchange rates in the future. An FEC is essentially a safety net for your business. 

Additionally, an FEC locks in a specified sum of money, typically with fees involved. For example, if you lock in $8,000 at the beginning of a contract but only need $6,500 at the end, there is a contractual cost to cancel this remaining portion.

Natural hedge

Foreign currency bank accounts are great natural hedges for businesses that currently sell overseas. For example, businesses who sell overseas from the US can receive their funds in a foreign currency such as AUD, GBP, Euros, and more. These US businesses can then leave it in a relevant foreign currency account without the need to convert to USD. 

Creating foreign currency bank accounts is a convenient way to manage your funds, especially if you have account expenses in foreign currencies. For example, you won’t have to worry about fluctuations in USD by simply holding your foreign currency in your foreign bank account. You also save on double conversion fees that banks sometimes charge — for example, converting from USD to GBP, and then back to USD. 

Foreign currency bank accounts

A simple way to manage foreign currency risk involves setting up a foreign currency account. Then, to hedge against risk, simply deposit the required amount (plus a nominated surplus) into the account. 

This method allows you to make the most of strong FX rates by converting and holding the foreign currency until you need to make a payment. It also ensures the correct funds are always available and considers potential currency fluctuations.

Contact Airwallex to manage your foreign exchange risk

If you need help managing your business’s foreign exchange risk, contact Airwallex today.  Sign up or call +1 (855) 932-3331 to speak with one of our product specialists.

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