What is foreign exchange risk?
Foreign exchange risk refers to the possible loss of international financial transactions due to currency fluctuations. Also known as currency risk, foreign exchange risk and exchange rate risk, it describes the likelihood that the value of an investment may decline due to changes in the relative value of the currencies involved. Investors may be exposed to jurisdictional risk in the form of foreign exchange risk.
Where does foreign exchange risk come from?
Foreign exchange risk arises when a company receives payments in one currency but pays fees in another. From the importer's point of view, the risk is that the foreign currency will appreciate because it means they will have to pay more for the imported goods. Instead, for exporters, the risk is that the foreign currency will depreciate against the Canadian dollar. If the exporter's foreign currency depreciates after selling to an international customer, the exporter's Canadian dollar will end up being lower than expected.
Companies are also exposed to foreign exchange risk when they create price lists at the start of the season, long before they invoice foreign customers, or when infrastructure projects require payment after each step of the project is completed. Once a formal agreement is reached with a supplier or customer, the company is at risk.
There is no one-size-fits-all strategy for reducing foreign exchange risk. A company's exposure is affected by many factors, including the volume of imports and exports, whether payment is made at the time of sale or at a later date, the currencies involved, and the countries where customers and suppliers are located.
All currencies fluctuate in value, and the Canadian dollar is no exception. Decisions about major interest rates by Canadian banks, energy prices, geopolitical conflicts, foreign acquisitions of Canadian businesses and many other factors can affect the value of our currency. Predicting currency movements is very difficult, and analysts' forecasts are not always reliable. That's why it's so important for companies to have policies in place to minimize this risk and protect their profitability.
Characteristics of foreign currency export sales
Applicability
Recommended for (a) highly competitive markets and (b) when foreign buyers insist on buying in local currency
Risk
Exporters are at risk of exchange rate losses unless foreign exchange risk management techniques are used
Advantage
Enhanced export sales terms to help exporters remain competitive
Reduce the risk of non-payment due to local currency devaluation
Shortcoming
The cost of using certain foreign exchange risk management techniques Foreign Exchange Risk Management
burden
Foreign exchange risk is divided into three categories:
Transaction Risk: This is the risk a company faces when purchasing products from a company located in another country. Product prices will be in the selling company's currency. If the selling firm's currency appreciates relative to the buying firm's currency, the firm making the purchase will have to make a larger payment in its base currency to reach the contract price.
Conversion risk: A parent company with a subsidiary in another country may face losses when the subsidiary's financial statements (which will be denominated in that country's currency) must be converted back to the parent's currency.
Economic Risk: Also known as forecast risk, refers to the continued exposure of a company's market value to the risk of inevitable currency fluctuations.
Companies exposed to foreign exchange risk can implement hedging strategies to reduce this risk. This often involves forward contracts, options and other exotic financial products that, if done right, can protect companies from unwanted foreign exchange fluctuations.
Currency Exchange Tips
Please be aware of any issues with currency exchange. Not all currencies can be freely or quickly converted into dollars. Fortunately, the U.S. dollar is widely accepted as an international trade currency, and U.S. companies can often ensure payments are made in U.S. dollars.
If the buyer requires payment in a foreign currency, you should consult an international banker before negotiating a sales contract. Banks can advise on any foreign exchange risk associated with a particular currency. The most direct way to hedge foreign exchange risk is forward contracts, which enable exporters to sell a certain amount of foreign currency at a pre-agreed exchange rate, with a delivery date ranging from 3 days to 1 year in the future.
If you can do business entirely in U.S. dollars, you may be able to avoid many of the difficulties and problems associated with currency exchange.
