5 Ways Companies Mitigate the Risk of Foreign Currencies

Image Source: Unsplash
 

Investing in or establishing a business in a foreign country comes with some risks. Some of them are obvious and easy to plan for, and others are less so. Foreign currency risk is an unforeseen risk that can have a significant effect on the profitability and efficiency of your investment or business. Exchange rate movements can and do affect how much a company receives in sales and how much it pays in expenses and to its suppliers. Here are some ways companies mitigate this risk.

Transact In Their Currencies

Companies in a very strong position have the option of operating in one currency, usually the currency of their home country. For example, a strong American company has the choice of invoicing and receiving payments in US dollars. This passes the exchange risk to their customers and suppliers because they do not have to deal with any exchanges in their transactions.

Doing so also allows them to only maintain one set of books because they would have to establish a different one for each currency they accept or conduct business with.

The biggest challenge to doing this is that these businesses would likely still have to maintain some local currency. Some expenses and costs like salaries and taxes will require this. A major exception t is international businesses that do business online as the use of credit and debit cards would allow their customers to pay in an international currency.

Hedging Using Forward Exchange Contracts

A forward exchange contract is a commitment to sell or buy a specific currency at an exchange rate determined at the time of writing a contract on a specific date in the future. The contract is typically written between a business and a bank or other financial institution. Such a contract protects the business from fluctuations in the foreign exchange rate between the two currencies mentioned in the contract.

The hedge takes into account the transaction fee and an adjustment that reflects the difference in the exchange rate of the two currencies. While most forward exchange contracts are written for 12 months, some can last longer especially if they involve major currency pairs.

To ensure everything goes right, the company must ensure that it receives the cash it needs to exchange before the specified date. This means the accounts payable or cash collection team must work with other departments to ensure this happens.

Allowing Everyone to Pay In The Same Currency

Even in cases where a business accepts only one currency, there are benefits to accepting one currency as the standard. For example, allowing its suppliers to pay in Dollars or Pounds would make things easier for everyone and remove the risk of foreign exchanges because there would be none.

This also applies to businesses that accept cryptocurrencies. Cryptocurrencies are a global digital currency that allows them to be used across borders without exchanging them for other currencies. Ethereum is particularly well suited for this because even though it was not meant to be one, it has become a medium of exchange.

Even though its value fluctuates from time to time, it remains a relatively popular cryptocurrency for those using it as a medium of exchange or using its network to build other applications. You can check out the historical value of Ethereum on different exchanges including OKX at https://www.okx.com/markets/prices/ethereum-eth, where you can also see how it trades against other digital and fiat currencies.

Hedging Using Currency Options

Currency options are very similar to forward exchange contracts, but with a significant difference. With currency options, the business has the right but not the obligation to buy or sell the currency at the given date.

Such contracts favor the company because it can choose to sell or keep its currency depending on where the resulting transaction would favor it. If the options exchange rate decided upon is higher than the spot market exchange rate, the business benefits and can complete the transaction (exchange). If not, the business can let the contract expire and conduct the exchange at the spot currency exchange rate which favors it.

Because of these options, an option contract includes an option cost that has to be paid if the business lets the contract expire.

Natural Foreign Exchange Hedging

Here, a company tries to balance its revenue and costs in foreign currency. This is so that the business operates in foreign currency without needing an exchange. This commonly happens when the business hires or sources its products or supplies locally.

Doing so helps simplify supply chains and is very effective for companies that have a presence in numerous countries. Even with these benefits, such hedging burdens the accounting team and the chief financial officer to keep track of all the different currencies at play and how much exposure the business faces.

Conclusion

Expanding a business and investing in a foreign country might be the next logical step, but you need to be aware of the risks associated with foreign exchange. The good news is that there are ways to mitigate these risks, as outlined above.