Foreign Exchange Risk Management Strategies

06.06.2023
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Business Insights

Foreign Exchange Risk Management Strategies

There are numerous advantages to conducting international business. It gives companies access to untapped market opportunities, expands their potential labor pool and offers a source of inexpensive raw materials.

However, cross-border trading also means dealing in different currencies, which typically have to be translated back to the domestic currency to properly assess business performance and record other financials. Currency values are naturally prone to fluctuation, and that can lead to significant financial losses if not managed properly.

It’s important for businesses to assess their exposure to foreign exchange (FX) risk and put the proper strategies in place to mitigate potential losses and maximize the value they derive from operating in foreign markets.

Most Common Foreign Exchange Risks Facing Businesses

Foreign exchange risk is a type of financial risk in which local currency values change in between transactions, which can negatively impact the dollar amounts companies receive from customers and pay to vendors.

Let’s say an American business — Company A — has a customer in the United Kingdom (UK). The rate of exchange between the two currencies is GBP 1 for every USD 1.25. The UK customer spends GBP 10 to pay for one unit of Company A’s product, which translates to USD 12.5 in the base currency.

However, in between the time Company A completes the sale and receives payment, the markets shift, and now GBP 1 only equals USD 1.1. A product sold for GBP 10 in the United Kingdom will now earn Company A just $11. Extrapolate that out to thousands of transactions across the world, and Company A has a serious problem.

Discrepancies like this one can manifest in several ways. Some of the most common types of foreign exchange exposure include:

Currency values can fluctuate between the sale and transaction: Companies can be exposed to foreign exchange risk when there are delays between completing a transaction and receiving payment. If a foreign buyer makes a payment but the foreign exchange rate changes before the seller receives that payment, the amount the business receives might be impacted. At scale, this could cause a serious drop in revenue.
International economic conditions can create currency instability: Political instability, natural disasters and economic uncertainty can all lead to a volatile financial climate that causes major fluctuations in a local currency’s value. Companies that operate in countries that are prone to any of those upheavals could expose themselves to greater foreign exchange risk.
Values can change when translating between foreign and domestic currency: Companies that operate subsidiaries in a foreign country typically have to translate cash denominations back to their domestic currency for reporting purposes. Depending on the degree of quality control during the translation process, stakeholders might mistakenly misreport data figures. This can lead to inaccurate business reporting and revenue losses.

Inaccurate financial statements (or, worse, mismanaged cash flow) can negatively impact all areas of the business, making it harder for other departments to properly budget, plan and pursue their own strategic initiatives.

Proven Foreign Exchange Risk Management Strategies

There are numerous financial instruments you can use to identify transaction risk and prevent it from harming your bottom line. As your foreign exchange service provider, Cathay Bank gives you access to a full range of solutions to help you mitigate your risk exposure and protect your cash flow.

Our foreign exchange risk management strategies include:

Spot contract: You can use spot contracts to buy or sell products and currencies at the exchange rate at the time of the sale, delivering and settling transactions as close to the sale as possible. This helps you avoid the sometimes steep foreign exchange rate fluctuations that can happen over the course of days or weeks while transactions are still pending.
Forward contract: A forward contract enables you to complete transactions (both payables and receivables) at a later point in time in accordance with a set exchange rate. That means you can process a transaction weeks after a sale is made and worry less about possible currency fluctuation that could change the amount you pay or receive.

Visit our website to learn about our other foreign exchange risk management solutions.

How Foreign Exchange Risk Management Helps You Achieve Your Business Objectives

Every company’s foreign exchange risk exposure is different. Depending on a variety of different business characteristics and geographic factors, it’s important you take the time to fully assess your business structure and identify the potential risks facing your businesses to put a proper risk management strategy in place.

This can be challenging, and many businesses don’t know where to start. Cathay Bank’s foreign exchange department team members can help you identify possible risks and properly navigate them to avoid revenue losses due to exchange discrepancies. Foreign exchange risk management team members will consider factors such as:

Countries of operation: Where you do business matters. Every country has a different level of political instability, regulatory environment, and economic conditions; each of which could impact currency values. Gaining an understanding of the inherent risks associated with the countries where your business operates can assist you in recognizing potential hazards and making proactive plans.
Investment portfolios: Some companies maintain investment holdings in foreign businesses, which often represent smart revenue-generating opportunities in a good economy. The value of those assets could be exposed to currency fluctuation, however, which could impact the ability of your business to collateralize debt and access capital.
Supplier/vendor locations: Even if you don’t sell to customers in foreign markets, you might source raw materials from foreign companies, an extremely common phenomenon in today’s highly connected global economy. This might still expose you to foreign exchange risk, as price fluctuations could cause you to pay more for vendor supplies or services.

Depending on the nature and degree of foreign exchange exposure, our foreign exchange department team members will help you build risk mitigation strategies that reflect the needs of your business. Minimizing foreign exchange risk puts you in a position to take full advantage of the opportunities of doing business across international borders.

Reduce Foreign Exchange Risk With Cathay Bank

National economies are more connected than ever, and many businesses today maintain operations across international borders. Cathay Bank’s foreign exchange department team members can help you identify and reduce your risk exposure and take full advantage of business opportunities in foreign markets.

The team at Cathay Bank will take the time to assess your individualized risk exposure and build a risk management strategy that’s right for you. Reach out to our team today to get started.