The Different Types of Foreign Exchange Exposure
Aug 3, 2022
By definition, a foreign exchange exposure refers to the risk of foreign exchange rates that change quickly and frequently. When this happens, it can greatly affect financial transactions with foreign currency rather than the domestic currency of a company.
For many businesses and corporations, foreign exchange rates are a constant risk that can affect the company's net income. It can cause monetary losses and threaten the success of a business. However, any business needs to overview the different types of foreign exchange exposures. Only then can a business prevent these losses and even make a profit from these risks.
Not only that, but getting currency protection for your business is another great way to shield your company from these fluctuating currency changes. Often, the world's economies are interdependent. In order to keep up trade relationships and goods and services, it is vital for businesses and companies to work with foreign partners.
In these situations, foreign exchange risks are unavoidable, and it is important for the companies to have a comprehensive overview of the risks. So, without further ado, below are the different types of foreign exposure that you need to be aware of so that you can properly protect your company's cash flow.
Foreign Exchange Exposure #1: Transaction Exposure
A transaction exposure happens when the company bills customers in foreign currency. For example, if they bill in British Pounds, the currency will depreciate in the timeframe the receivable is booked and collected. This is incredibly difficult to manage because currencies will always fluctuate in value, resulting in financial loss.
This is part of the reason why most companies opt to bill in the currency of their own country as they will be able to collect in their local currency, which will prevent any potential loss. This is why it is very important to check if your business runs this type of foreign exchange exposure.
How Do You Run a Measurement on Transaction Exposure?
Unfortunately, you cannot run a measurement for transaction exposure without specificity since exchange rates fluctuate all the time, and for a plethora of reasons. However, if you really need to, the most you can do is track historic exchange rate to find the difference between two currencies so you can predict close currency fluctuations.
Thankfully, there are some websites that can help you with this. If you're wondering what factors you should consider, the length of the transaction is one of the biggest factors. If you have a long-term contract of five years, you'll have a great risk of having to deal with fluctuating exchange rates.
What are the Gains and Losses of Currency Exchange?
While you can't really predict the change that will happen as various currencies fluctuate, what you can do, however, is compute the gains and losses of the currency exchange.
The gains and losses can come in various forms. It can be in the form of interest income on your borrowings, and it can also take the form of a depreciation loss in your income statement when the value of your assets decline in value.
Getting currency protection is crucial for issues like this to ensure that you're keeping in mind the losses you've accumulated to help lower your financial risk.
Foreign Exchange Exposure #2: Translation Exposure
When it comes to a translation exposure, this puts the company's equities, liabilities, assets or income at risk because the value of exchange rates will fluctuate over time. This happens when a firm denominates a portion of its equities, income, and alike in a foreign currency. This is also known as accounting exposure.
How Do You Measure Translation Exposure?
There's no denying that translation exposure can give an inaccurate representation of the company's holdings, especially when foreign currencies depreciate compared to your home currency.
For this reason, accountants will choose from various options that will convert foreign holdings close to your domestic currency. With this, they can choose whether to convert at the current exchange rate or at a historical rate.
Current/Non-Current Method: This method is the easiest way to convert foreign holdings to your domestic currency. You simply have to use the exchange rate of the current time. However, this method will greatly inflate your earnings, which means you'll have to consider the method of historical rates, which is shown below.\n
Monetary/Non-Monetary Method: With this method, the accounts are converted at the current rate of the exchange, and non-monetary, on the other hand, are converted at a historical rate. Usually, companies choose monetary methods for fixed amounts of money received or paid using cash, creditors, loans, and debtors.\n
Current Rate Method: This method uses the latest exchange rates that are provided by the country's central bank. You can use this method when the market rates are consistently higher than the official rates.\n
Temporal Method: This is quite similar to monetary/non-monetary method, but with this method, inventory is taken into account. Here, the value of inventory is converted using historical rate. However, if the balance sheet records inventory with the current market value, then it is converted to the rate of exchange at the moment.
Foreign Exchange Exposure #3: Economic Exposure to an Exchange Rate
Economic exposure is also called operating exposure. With this, it measures the change in the cash flows of your company, resulting in unexpected changes in foreign exchange rates.
With this, accountants use different methods to help protect firms from these types of risks, such as integrating consolidation techniques and effective evaluation procedures.
It's important to note that unanticipated rate changes can affect your company's cash flow. And with an economic exposure, it could cause serious consequences to your company's profitability and operations. Not only that, it could also affect your company's position.
For this reason, it's worth getting currency protection for business so you can integrate techniques that will help mitigate your gains and losses due to the fluctuating tendencies of currency exchange.
There are a lot of consequences for economic exposure to an exchange rate, and this is one of the reasons why it is crucial to invest in currency protection for businesses to minimize the loss.
How Do You Mitigate Economic Exposure?
Operational Strategy: With this strategy, you get to adjust or change your company's operations to avoid risks associated with currency fluctuations. With that, you need to diversify the production facilities and markets of your products, and expand operating facilities and sales to a mixture of markets.
Currency Risk Mitigation Strategy: With this strategy, the goal is to mitigate the currency risk to minimize or avoid economic exposure through hedging. With that, you can do the following:\n
Matching Currency Flows: Your company will match the foreign currency outflows with currency inflows from foreign currency.\n\n
Currency Risk-Sharing Agreements: Both parties enter a currency risk-sharing agreement so both parties share currency risk.\n
Currency Swap: Companies can use this method to get required cash flows at the desired exchange rate.
Foreign Exchange Exposure #4: Contingent Exposure
A contingent exposure focuses on items that have an impact on the cash flows of the firm. With this exposure, you have a limited or short time horizon. Here are some examples of such exposures:
The import and export deal has yet to be negotiated and prices have to be finalized. With that, the fluctuations in exchange rate will influence both parties and could be converted to transaction exposure.\n
If a company submitted a tender bid on an equipment contract. If awarded, the transactions will risk exposure.\n
When you import a product from abroad and sell it in the local market. Because you'll be using your home currency for your price list, the revenues may differ and are exposed to currency fluctuations.
The main goal of measuring the contingent exposure of a firm is to determine the risk to your business by estimating the costs that will come with a currency fluctuation. The measurement of contingent exposure is based on the direct costs and expenses incurred when the prices change because of an exchange rate.
Foreign Exchange Exposure #5: Competitive Exposure
Competitive exposure is the change that happens in a company's competitive environment in the event of currency fluctuations. This explains why they're tied to competitive risk.
For example, if a company has a competitive exposure to an exchange rate, they're at a competitive disadvantage when they have to compete against firms that have lower production costs.
This type of exposure touches on long-run changes in exchange rates and covers the effects of over- or undervalued dollars. Understandably, this can be incredibly confusing. For this reason, it's best to speak to experts who understand the foreign exchange risks you may be facing.
Can A Hedging Platform Help Mitigate Foreign Exchange Exposure Risks?
A hedging platform is a secure place to store your transactions so you can keep track of all transactions. This platform is made up of a group of hedging specialists who are responsible for matching buyers and sellers of currency options.
They take care of the currency exchange and the settlement of options, and they also assist you with your currency settlement and payments. With the use of this platform, you can take advantage of currency exposure hedging tools.
One of the most important features of a hedging platform is that it allows you to manage your exposure by converting it into a gain or loss.
How Do I Choose the Right Platform?
When it comes to choosing a currency protection for businesses, here are some things that should be considered:
It Should Address the Needs of Your Business: A platform is useful if you're able to address the needs of your business. You need to decide which hedging platform works best for your business based on your current status and the goals you want to achieve.\n
It Should Help You Understand the Foreign Exchange Situation: You need to choose a platform that will help you understand the foreign exchange situation so you can better determine your risk\n
It Should Provide You with Real-Time Exchange Rates: Knowing real-time exchange rates will help lower your risk and losses.\n
It Should Integrate to Your Accounting Platform: Seeing as your accountant will handle all the finances of your company, it's crucial that your foreign exchange platform works seamlessly with your accounting platform. This way, your accountant will be able to use the database with ease, creating accurate reports and financial statements that will support the growth of your company.
The Bottom Line: Use a Currency Protection Platform to Help Shield Your Business from Foreign Exchange Risks
As you can see, foreign exchange exposure has a lot of risks that can affect your company in terms of its financial stability. For this reason, it's important to mitigate your risks as much as possible to assure that your firm will be covered in the event that a foreign exchange exposure hits your company.
For this reason, you need to get a currency protection platform that can help you get the most benefits and opportunities to help you mitigate any risks you may be facing. Thankfully, Bound is a platform that can help you with just that. With the proper tools to help you manage your company's foreign and local finances, you'll be able to maximize your cash flow and take your business to even greater heights!
How Can We Help You?
If you're looking for solutions for ,currency protection for businesses, you've come to the right place.
Bound helps your company stop overpaying for your foreign exchange. With our platform, you're able to facilitate trade whenever you need to, experience seamless hedging, since everything is automatic, smart, and integrated into your system.
Bound has the solution for your business. We'll show you how you can easily manage and reduce your risks with our hedging platform. We'll walk you through the process from the setup to the maintenance to ensure that you're making fast, smart decisions for your company.
So, if you're curious about our platform, watch our recorded demo or book a live demo today!