What currency risk means
Currency risk is the chance that a movement in exchange rates changes the value of something your business cares about: a payment, a receipt, a balance, a profit margin or the value of an overseas operation. It runs both ways. Rates can move in your favour as easily as against you. The risk is the uncertainty itself.
Finance textbooks divide currency risk into three types: transaction, translation and economic exposure. The labels sound technical, but each describes something a business owner will recognise. They differ in how soon they hit cash, how visible they are and how much a business can do about them.
This guide explains each in plain terms and then looks at practical, everyday ways to manage the timing of conversions. It does not cover derivative products, which are specialist instruments with their own risks and are outside the scope of this article.
Transaction exposure
Transaction exposure arises when you have agreed to pay or receive a fixed amount of foreign currency at a future date. Between the date you commit and the date you convert, the rate can move, changing the amount in your own currency.
A Canadian retailer orders stock from an Italian manufacturer for EUR 200,000, payable in 60 days. At today's rate, the order costs a certain number of Canadian dollars. If the euro strengthens over those 60 days, the retailer will need more Canadian dollars to pay the same invoice. If it weakens, the retailer will need fewer. The retailer's margin on the stock depends on a number it cannot know when it places the order.
Transaction exposure is the most visible kind of currency risk because it turns into cash quickly. It is also the kind a business can most directly manage, because it relates to specific, known payments.
Translation exposure
Translation exposure affects groups with foreign subsidiaries or foreign currency assets and liabilities. When a group prepares consolidated accounts, it translates each subsidiary's results and balance sheet into the group's reporting currency. As rates move, the translated figures change, even if nothing has happened inside the subsidiary.
A Vancouver parent owns a Hong Kong subsidiary that holds HKD 10 million in its bank account. If the Canadian dollar strengthens against the Hong Kong dollar between one year end and the next, the same HKD 10 million is worth fewer Canadian dollars in the group accounts. No cash has moved and no conversion has taken place, but reported equity is lower.
Translation exposure is an accounting effect. It can still matter a great deal, for example where bank covenants are measured on consolidated figures, or where investors focus on reported results. How it is presented in the accounts depends on the accounting standards the group uses. That is a matter for the group's auditors and advisers.
Economic exposure
Economic exposure, sometimes called operating exposure, is the long-term effect of exchange rates on a business's competitive position and future cash flows. It is the broadest and hardest to measure.
A Polish software studio that sells services to clients in Germany and pays its developers in zloty has an obvious transaction exposure on each invoice. Its economic exposure goes deeper. If the zloty strengthens a long way against the euro over several years, the studio's costs rise in euro terms, and it may find itself less competitive against studios in countries where costs have not risen. That changes the business itself, well beyond any single invoice.
Economic exposure is managed through business decisions more than treasury techniques: where to locate costs, which markets to sell into, which currency to price in and how much flexibility to build into contracts.
Mapping your exposures
Before deciding anything, write down what you actually have. A simple exposure map can be built in a spreadsheet in an afternoon.
- List every currency your business receives and every currency it pays.
- For each currency, estimate monthly receipts and payments for the next six to twelve months.
- Net them off to show the surplus or shortfall in each currency by month.
- Note which amounts are firm, such as signed orders and contracted salaries, and which are forecasts.
- Add any foreign currency balances you hold and any foreign subsidiaries whose results you consolidate.
| Currency | Expected receipts per month | Expected payments per month | Net position |
|---|---|---|---|
| USD | 600,000 | 250,000 | Surplus 350,000 |
| EUR | 0 | 180,000 | Shortfall 180,000 |
| PLN | 0 | 420,000 | Shortfall 420,000 |
The figures above are an illustrative example for a hypothetical company. Even a rough map like this shows where the real exposures are, and often shows that some of them partly cancel each other out.
Matching currencies
The simplest way to reduce transaction exposure is to match the currencies you receive with the currencies you pay. If you earn US dollars and also have US dollar costs, using the receipts to pay the costs removes the conversion on that portion entirely. Only the net surplus or shortfall needs converting.
Matching can be built into commercial decisions. A business that buys components in euros might choose to invoice some customers in euros. A group with a large US dollar income might choose suppliers who accept US dollars. A company opening an overseas office might fund it partly from revenue earned in that same currency.
Matching does not remove risk on the net position, and it can move risk to the other party. A supplier who agrees to be paid in your currency takes on the conversion, and may price that into the contract. Matching works best where it reflects genuine commercial flows.
Timing conversions
Every conversion has a timing decision attached. You can convert when an obligation is agreed, when it falls due, or at some point between. None of these choices removes uncertainty, and none should be based on a view of where rates are heading. They are choices about when to fix a known cost.
- Converting when the invoice is agreed and holding the bought currency until payment fixes the cost early. It ties up cash in the foreign currency for the intervening period.
- Converting when payment falls due keeps cash in your own currency for longer, but leaves the cost open until the last moment.
- Converting in instalments, for example converting a quarter of a known future requirement each week, spreads the conversions across several rates. The result is an average rate over the period, which smooths out the effect of any single day.
For a business that is new to this, a short written treasury policy helps. It need only say which currencies the business deals in, who may book conversions, how far ahead known payments are converted, what balances may be held in each currency and how results are reported to management. One page is usually enough. Its main value is that decisions are made in advance, calmly, and not in a hurry on the day a large invoice falls due.
Whichever approach you choose, write it down and apply it consistently. Treasury policies that change with the mood of the market tend to produce worse outcomes than plain, steady ones.
Holding currency balances
Holding foreign currency balances can help where receipts and payments in that currency happen at different times. A business that receives US dollars at the start of the month and pays US dollar suppliers at the end can keep the receipts in a US dollar bank account in between, avoiding two conversions.
Balances carry their own considerations. Money held in a foreign currency is itself exposed to rate movements when measured in your home currency. Banks may pay little or no interest on some currency accounts. Holding large idle balances ties up working capital. And funds left with a payment provider pending onward payment are not the same as a bank deposit and are generally not covered by deposit insurance.
A sensible middle course is to hold balances that match known near-term payments in that currency and to convert surpluses back on a regular schedule.
Pricing and contract terms
Some of the most useful tools for managing currency risk sit in your commercial contracts. They are agreed once and then work quietly in the background.
Choice of invoicing currency. Pricing in your own currency moves the exposure to your customer. That may be acceptable to them or may cost you business. Pricing in the customer's currency keeps the exposure with you but can win sales.
Price review clauses. Long-term supply contracts can include a clause allowing prices to be reviewed if the exchange rate moves beyond an agreed range from a reference rate. Both sides then share the effect of large movements.
Payment terms. Shorter payment terms reduce the period over which transaction exposure exists. A 30-day invoice is exposed for half as long as a 60-day one.
Price list reviews. If you publish foreign currency price lists, review them on a fixed schedule so that rate movements feed through to prices in an orderly way.
Derivatives such as forwards and options are also used by some businesses to manage exposure. They are specialist products with their own risks and obligations, and whether they are appropriate is a question for a regulated adviser. CCYFX does not offer them.
General information
This article is general information about currency risk. It is not investment advice and does not recommend any product, strategy or course of action. Examples are hypothetical. For your own circumstances, speak to a qualified adviser. CCYFX provides spot FX and international payments for businesses. See our foreign exchange page for how spot conversions work with us.
