What is foreign currency risk?
The exchange rates of currencies such as the euro, US dollar, Swiss franc and Turkish lira, which are freely traded on the market, are not fixed, but sometimes fluctuate considerably. Foreign currency risk, or exchange rate risk, refers to the financial risk that results from fluctuations in the value of a base currency against a foreign currency in which a company has assets or obligations.
Foreign currency risk: the euro and the dollar as examples
The impact of currency fluctuations on purchasing is nicely illustrated by the following example: between January 2021 and September 2022, the euro lost more than a fifth (around 21%) of its value against the US dollar.
Since then, the euro has strengthened again. This was due to the monetary policy of the European Central Bank, which had gradually raised interest rates in the eurozone due to inflation, and higher interest rates usually make a currency more valuable. In other words: under these circumstances, dollar-based transactions yield fewer euros.
Even over shorter periods of time, foreign exchange can develop in such a way that - depending on the type and size of a transaction - even small differences have a significant effect on profits or losses.
Let's say a British company sold a machine to a US company on November 3, 2023. The machine was to be delivered to the USA a good ten days later on November 12 and only paid for at this point. The price agreed upon conclusion of the contract was 500,000 US dollars. One US dollar was then worth exactly 0.887 GBP. The British company would therefore expect revenue of 444,350.00 GBP at the point of sale.
But then the exchange rate changed. At the agreed delivery and payment date on November 12, one US dollar was worth the equivalent of just 0.84 GBP. So the equivalent of the agreed 500,000 US dollars was 420,000.00 GBP. The British company therefore achieved a turnover of 24,350 GBP less than expected for its machine: a decline of around 4.8% within the space of a few days.
How to avoid foreign currency risks
There are various options for UK buyers and sellers to protect themselves against foreign currency risk:
Invoicing in sterling
Invoicing in domestic currency: you can choose to invoice in sterling. This transfers the risk of exchange rate fluctuations to your overseas business partners. However, it is usually costly for the overseas partner to take on the risk.
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Taking out a foreign currency loan
The foreign currency loan is taken out in another currency and is also repaid in this currency. So the British seller in our example above takes out a loan of 500,000 US dollars. If the buyer pays the agreed 500,000 US dollars, the seller uses them directly to repay the loan. It’s important to keep an eye on the interest accruing to the lender, but - as in our example - this is usually far below a possible loss.
Concluding a forward exchange transaction
If several years elapse between the conclusion of the contract and payment, it is possible to conclude a forward exchange transaction as a safeguard. The seller sells the foreign currency, which they only receive later, at a fixed rate. However, as a rule, only low exchange rates are offered, since it’s impossible to predict future price trends.
Taking out an insurance policy against foreign currency risk
Companies can also protect themselves against foreign currency risk with special insurance policies. Many insurance companies include such offers in their portfolios.
If you only trade in the UK, you don’t need to worry about foreign currency risk. Everyone else needs to be aware that exchange rate risks are ever-present, and you must actively safeguard against them. You can find information on how to do this from the World Bank and the Organisation for Economic Co-operation and Development (OECD).