Foreign exchange (FX) investments can come with high risks. For instance, the exchange rates for foreign currency can fluctuate greatly, impacting the value of foreign assets and exposing you to liabilities. Foreign exchange risks can also have a significant impact on businesses that operate internationally, as they can affect profitability, cash flow, and competitiveness. Here are some ways to help identify and mitigate foreign exchange risks to ensure long-term financial stability.
Understand the nature of foreign exchange risks
There are several types of foreign exchange risks, including transaction risk, translation risk, and economic risk.
- Transaction risk arises from losses that international transactions may incur due to currency fluctuations before the transaction is complete. Essentially, the time delay between transaction and settlement is the source of transaction risk. Transaction risk can be mitigated using forward contracts and options.
- Translation risk refers to the risk faced by a company headquartered domestically but conducting business in a foreign country, and when the company’s financial performance is denoted in its domestic currency. Translation risk is higher when a company holds a greater portion of its assets, liabilities, or equities in a foreign currency.
- Economic risk, also known as forecast risk, is the risk that a company’s market value is impacted by unavoidable exposure to exchange rate fluctuations. Such a type of risk is usually created by macroeconomic conditions such as geopolitical instability and/or government regulations.
Analyze exposure to foreign exchange risks
It’s important to analyze your business’s exposure to these risks by identifying all the assets, liabilities, and transactions that are performed in foreign currencies and assessing the potential impact of exchange rate fluctuations on their value. This analysis should include an assessment of the company’s foreign currency cash flows, including receipts and payments.
Develop & implement risk management strategies
Based on the analysis of exposure to foreign exchange risks, your company should develop a risk management strategy that includes a combination of risk mitigation and risk transfer techniques. Risk mitigation techniques include hedging strategies such as forward contracts, options, and futures contracts.
These hedging strategies typically involve two parties agreeing upon buying or selling an asset at a set value in the future, to ensure your business gets the price desired, regardless of currency fluctuations.
Risk transfer techniques include outsourcing, insurance, and risk-sharing agreements.
To effectively implement your risk management strategy, you’ll need to establish clear policies and procedures for managing foreign exchange risks (such as setting limits on foreign currency exposure), manage hedging contracts, and monitor exchange rate fluctuations. It’s also important to train employees on these policies and procedures and to ensure that they are implemented consistently across the organization.
Monitor & review risk management strategies
Finally, businesses should monitor and review the effectiveness of risk management strategies on a regular basis by tracking foreign currency exposures, assessing the performance of hedging strategies, and reviewing the impact of exchange rate fluctuations on the company’s financial performance. If necessary, the strategy should be adjusted to ensure that it remains effective in mitigating foreign exchange risks.
Foreign exchange risks can have a significant impact on the financial performance of companies that operate internationally, but those risks can be identified, managed, and mitigated. At Valley, we’re working to help companies minimize their exposure to foreign exchange risks and ensure their long-term financial stability.
For informational/educational purposes only. The information in this content is not advice on legal, tax, investment, accounting, regulatory, technology or other matters. You should always consult your own financial, legal, tax, accounting or similar advisors before making any financial or investment decisions, or entering into any agreement for Valley products or services. Copyright © 2023 Valley National Bank. All Rights Reserved.