How to mitigate exchange rate risk: a complete guide

In today’s financial world, efficient management of exchange rate risk has become an urgent necessity for many companies, especially those operating internationally.

This risk, associated with the fluctuation of foreign currency relative to the domestic currency, can significantly impact the financial operations and economic stability of organisations that engage in international transactions.

But do you know what exchange rate risk refers to and how you can mitigate it? We’ll explain it to you below.

What is the exchange rate?

The exchange rate is a financial concept that refers to the value of one currency in terms of another. It is the rate at which one currency can be exchanged for another, playing a crucial role in international trade and the global economy.

The exchange rate is usually expressed as a ratio or proportion, indicating the amount of one currency needed to buy one unit of another. For example, a currency pair like EUR/USD shows the value of a U.S. dollar relative to the euro. For instance, if 1 EUR = 1.05 USD, it means you need 1.05 dollars to buy one euro.

Exchange rates fluctuate constantly due to various economic, political, and social factors. In fact, they change in real time, especially in the FOREX market (Foreign Exchange Market), which is the largest and most liquid financial market in the world, with €220 billion traded every hour.

In FOREX, traders, ranging from individuals to banks and other financial institutions, buy and sell currencies from different countries, which in turn affects their relative values.

Why is the exchange rate so important?

The exchange rate is a fundamental pillar of the global economy, and its importance can be attributed to several critical factors that impact both the macroeconomic and microeconomic levels.

More specifically, it is highly relevant in international trade, as it affects the price of imports and exports. A favourable exchange rate can improve the competitiveness of a country's products in the global market. On the other hand, when the exchange rate is unfavourable, it can reduce sales of goods or services being sold abroad.

Moreover, the exchange rate also impacts investment in companies. In general, investors seek opportunities in countries with favourable exchange rates to maximise their returns.

Understanding the risks associated with exchange rates?

Exchange Rate Risk, also known as , refers to the possibility of incurring financial losses due to fluctuations in the value of one currency relative to another. This phenomenon is a constant reality for businesses and investors involved in international trade and investment.

The most evident risk materialises when there are different time horizons in a transaction. For example, imagine a Spanish company that has closed a contract to supply components to a U.S. company worth 5 million U.S. dollars (USD), at an exchange rate of 1 EUR = 0.90 USD. In this case, the contract value in euros is 4,500,000 €.

The payment will be made in three months, at which point the new exchange rate is 1 USD = 0.80 EUR. This means that, at the time of payment, the contract value in euros is 4,000,000 €. In other words, a loss of 500,000 € has occurred due to the time difference between the signing of the contract and the payment moment.

In reality, there are several types of currency risks, including:

• Transaction risk: this arises from international commercial operations where payments or collections are made in foreign currencies. Specifically, the fluctuation in the exchange rate between the transaction date and the payment date can affect profit margins, as losses may be incurred due to currency fluctuations.
• Translation risk: this affects multinational companies when consolidating the financial statements of their foreign subsidiaries into the local currency. Fluctuations in the exchange rate can impact the consolidated balance sheets and results.
• Economic risk: this is related to the long-term impact of currency fluctuations on the present value of a company’s future cash flows. 

What factors influence exchange rate risk?

Several factors can influence the fluctuation of currencies, and understanding them is crucial for managing exchange rate risk.

These include:

• Economic indicators: Some variables, such as GDP, inflation, and interest rates, can influence the strength of a currency. Paradigmatic examples of the relationship between macroeconomic variables and exchange rates are Argentina and Venezuela, whose inflation levels in recent years have caused the value of their currencies to collapse internationally.
• Political stability: political events, governmental decisions and political stability can impact the confidence of investors and therefore the strength of the currency. This happened during the last presidential elections in the United States, it had a notable impact on the US dollar. The political uncertainty prior to the election and the political transition affected investors confidence and caused fluctuations in the value of the dollar 
• Market sentiment: The perception and reaction of investors to global events can cause rapid and significant fluctuations in exchange rates. This was the case with the culmination of Brexit at the end of 2021. The United Kingdom’s departure from the European Union affected the British pound due to prolonged negotiations and uncertainty about the terms of the trade agreement.

The impact of exchange rate risk on businesses and investors

Exchange rate risk can have significant consequences for both businesses and investors:

• Businesses: currency fluctuations can affect the costs of imports and exports, profit margins, and, in general, their global competitiveness. Multinational companies may face additional challenges in consolidating financial statements and managing foreign investments.
• Investors: investors who hold assets in foreign currencies may experience variations in investment returns due to exchange rate fluctuations. Geographic diversification of investments can expose investors to additional currency risks.

How to reduce the impact of exchange rate risk?

In a globalised economic environment, effective management of exchange rate risk is essential for the financial stability of any business with international operations and payments. There are several tools to manage this risk. Below, we explain some of the key tools:

Currency diversification

Diversifying across different currencies can be an effective strategy to spread the risk. Holding assets and conducting transactions in multiple currencies allows businesses to offset potential losses in one currency with gains in another.

Financial derivatives

Financial derivatives give companies the ability to lock in exchange rates for future transactions, providing coverage and protection against market volatility. Some of the key financial derivatives for managing exchange rate risk include:

• Forward contracts: these are customised agreements between two parties to buy or sell a specific amount of foreign currency at a predetermined price on a future date. They are not traded on an exchange and are completely customisable. They are ideal for companies with known future obligations in foreign currency, such as import payments or receipts from exports.
• Currency options: these offer companies the right, but not the obligation, to buy or sell currency at a predetermined price. They are useful for companies and investors who want to hedge against exchange rate fluctuations while also taking advantage of favorable currency movements.
• Currency swaps: these are contracts in which two parties agree to exchange two cash flows in different currencies over a specified period. They combine elements of forward contracts and loans in different currencies. This instrument is commonly used by multinational companies and investors to manage exposure to exchange rate risk, finance investments in foreign currencies, and improve liquidity management efficiency.

Implementation of treasury management software

In the digital age, technology plays a crucial role in the efficient management of exchange rate risk. Specialised treasury management software, such as Embat, can be an invaluable investment for companies.

• Automation: the software automates complex and repetitive processes, improving efficiency and reducing human error.
• Real-time analysis: it provides real-time analysis and insights into financial data, allowing companies to make informed decisions quickly
• Simulation Scenarios: it allows companies to simulate different scenarios to assess the potential impact of exchange rate fluctuations on their operations
• Data Integration: the software integrates data and information from multiple sources to provide a comprehensive view of exposure to exchange rate risk and mitigation opportunities
• Predictive analysis: modern treasury management systems are equipped with predictive analytics capabilities. They use advanced algorithms and machine learning to forecast trends and fluctuations in exchange rates, enabling companies to anticipate and prepare for future variations

Include contract clauses and billing in local currency

Incorporating contractual clauses that allow for adjustments based on exchange rate fluctuations can protect businesses from unexpected volatility. Additionally, invoicing international transactions in the local currency can reduce exposure to exchange rate risk.

Conclusions

As we have seen, exchange rate risk is a challenge for businesses and a real headache for many treasurers. Therefore, it is essential for companies to manage exchange rate risk effectively. This is not only important for daily operations but also crucial for developing a strategic vision that incorporates exchange rate risk management.

This involves staying informed about global economic trends, monetary policies, and geopolitical events that may influence the valuation of currencies.