What is Currency Risk?
Nov 15, 2021
If your company trades with suppliers or customers in other countries then you likely have to deal with foreign currencies in your business and you likely have currency risk hiding in your finances. Dealing with foreign currencies and currency risk can range from a mild annoyance to a business-critical function depending on many factors in your operations.
How Much Currency Risk Do I Have?
As a thought experiment, ask yourself - if currency exchange rates moved dramatically, could this impact your business’s profitability? Or would this cause significant operational pain--like needing to adjust pricing to all your international customers or renegotiating contracts with suppliers?
If you answered yes, then your business faces currency risk. Generally speaking, currency risk comes from having costs in one currency and revenue in another. Differences in the timing of paying costs and collecting revenue exacerbate the problem.
In practice, currency risk comes in many shapes and sizes:
A British importer manufactures its products in Asia and pays its suppliers in USD, but sells its products primarily in the UK for GBP
A French technology company employs a French workforce with EUR but has American customers paying in USD
A US exporter sells its products in Europe and the UK for EUR and GBP
An Irish software company hires remote software developers based in various countries and agrees to pay salaries in local currencies
A Belgian consulting firm opens a new overseas office with local staff - it needs to pay legal startup costs, rent, and salaries in local currency.
A fruit and vegetable importer makes large purchases in local currencies where the product is grown and sells in the UK & Scandinavia, but operates on thin margins--a small currency fluctuation can eliminate profits
The extent and importance of currency risk vary depending on the company’s business model. In 2020, amidst the global Covid-19 pandemic, exchange rates were more volatile than in recent years. For example, the USD/GBP exchange varied by as much as 20 percent. Through most of the pandemic, USD weakened to GBP.
If a British company collects exclusively USD revenue and pays exclusively GBP costs, then it could have realized as much as 20 percent loss in GBP revenue during the pandemic. A simple example will illustrate.
In March 2019 the British company signed a two-year annual with an American customer for $1,000,000 per year, payable in March of 2020 and March of 2021. The British company expects to receive approximately £760,000 from each payment to cover its costs and make a profit based on the exchange rate at the time.
In March 2020 this British company collected $1,000,000 in revenue from its American customer and converted it to Pound Sterling. Pleasantly surprised by the exchange rate, the company actually realized £862,000 and made an extra profit.
In March 2021 the British company received the second payment of $1,000,000, but because USD weakened substantially during the pandemic, the British company only realized £719,000 and the company couldn’t cover its costs and realized a loss.
Most real-world examples are not so clear-cut and have more moving parts, but hopefully, this illustration makes the principle clear.
To completely understand your currency risk, you’d need to:
Outline the timing and amounts of all company outflows in local and foreign currencies
Outline the timing and amounts of all company inflows in local and foreign currencies
Line them up to look for any natural hedges. A natural hedge is when a company has a cost in a foreign currency, but also has some offsetting revenue in that currency, so those amounts are not at-risk to currency fluctuations.
Identify the timing and quantify the amount of the risk as it changes in time
Is Currency Risk Worth Solving?
But is solving for currency risk even worth it? Perhaps you’ve been doing business without managing your currency risk for many years and you just view this as a cost of doing business. And isn’t it true that I’ll win on exchange rates as often as I lose--does it all balance out in the end?
Whether or not solving currency risk is worth the effort depends on your business. Some questions to consider are things like:
Would a 5 percent adverse currency swing significantly impact my business, or could I weather that easily? These types of movements are quite common.
Could I also absorb a more dramatic change, like 20 percent? These happen less frequently so can I deal with these periodically?
How easily and how accurately can I project the timing and amounts of my foreign transactions?
How well do I understand the basic financial products to manage these risks?
Transacting in multiple currencies brings currency risk. The choice to manage this risk or leave it unmanaged is up to each company. Managing currency risk takes some time and effort, but can protect the business from currency fluctuations. Choosing to leave currency risk unmanaged is easy, but moving exchange rates can impact the company’s profitability. You’d likely avoid a contract with a supplier that may-or-may-not have a 20 percent fluctuation in the price based on the day of payment. But that’s exactly what we all do without thinking about it when we agree to take on currency risk.
If you have a small amount of money at risk and you can weather potential losses, sometimes it makes sense to do nothing. However, most firms can benefit from being more proactive. The key is not to let a small problem command a large-scale solution.
Bound Makes It Easier
The fact is that almost all large companies have professionals that manage currency risk. Large, international companies often have millions at risk and value predictability in costs and revenue. They can afford to hire or work with risk professionals to protect their businesses. For large-scale problems, they work with a bank or an FX broker on a large-scale solution with financial projections, risk analysis, and complex hedging strategies.
However, most smaller businesses don’t have the time or resources to commit to even understanding where currency risk is hiding in their operations--let alone putting together packages of financial products that would help mitigate these challenges.
Bound aims to make this entire process easier. We’re developing products to help businesses more easily identify currency risk and then mitigate that risk. Our goal is an automated and integrated solution that provides the benefit that large companies get from professional risk managers, but for companies that don’t have the extra time or money--whatever the currency. Best of all, with Bound, there is no finance degree required.