Currency-related risks are inherent to some businesses, and it is critical to address these risks in time and with proper strategies. Managing currency risk is also a critical part of international business that deals with several currencies to conduct business in several countries. Fluctuations in exchange rates can seriously impact business profitability and expenses, especially in the case of transnational companies. Let’s analyze and describe strategies to minimize currency-related risks, ensuring your business remains stable and profitable even when there are volatile times.
Currency risk types explained
Before you can effectively manage currency risk, it is essential to understand the different types of risks that can affect your business:
• Transaction risks — Occurs when a company has transactions in foreign currencies. Fluctuations in exchange rates during this period can impact the final amount paid or received.
• Translation risk — Affects companies that operate in multiple countries and need to consolidate financial statements. In this case, the changes in exchange rates can affect the reported financials when converting foreign currencies to the home currency.
• Economic risk — Long-term market changes can influence a company’s competitiveness. A strong home currency, for example, can make exports more expensive, reducing competitiveness abroad.Defining the type of currency risks present for the business is a critical step to developing viable strategies to mitigate these risks and ensure stability for the business. Let’s now switch to the most effective strategies to counter currency risks.
Hedging strategies
The most popular strategy is hedging the FX exposure by opening an opposite position to mitigate currency rate risks. While very effective, hedging is a complex method and requires a deep understanding of the market correlation between different currencies and acting swiftly. Here are the most popular hedging strategies:
• Forward contracts — Locking in the exchange rate for a future date, providing certainty about future prices.
• Options — Currency options allow firms to be more flexible and mitigate potential risks in the future.
• Futures contracts — Similar to forwards, futures allow buying or selling a currency at a set date in the future.There are other hedging types available for businesses that can be used depending on the business status.
Natural hedging implementation
Natural hedging means structuring your operations to minimize currency risk without using financial instruments, including matching revenue and expenses, and foreign currency accounts. Matching revenue and expenses means trying to match revenue and expenses in the same currency to reduce the need for currency conversions. Another effective way is to maintain accounts in foreign currencies to manage cash flow and reduce the need for immediate currency conversions.
Hedging is not the only strategy used by companies to effectively mitigate currency rate risks.
Diversify currency exposure
Diversification allows investors and businesses to spread the risk across several uncorrelated asset classes. It is a key principle in risk management, widely used in both trading and investing. Popular methods for diversification include operating in multiple currencies. By conducting transactions in several different currencies, companies can balance out the effects of currency fluctuations. Another method is geographic diversification, which includes expanding the business operations across different regions, which helps to spread out currency risk and reduce dependency on any one market. Surely the latter option is for companies that control considerable capital and can open new branches in different countries.
Monitoring the currency markets
Businesses can anticipate currency risks by staying informed about important currency trends and forecasts. One effective way to measure the heartbeat of Forex markets is to use the economic calendar and monitor key economic indicators regularly. The most essential indicators include interest rates, inflation, employment rates, GDP, and central bank monetary policies. Checking exchange rates and analyzing critical macroeconomic indicators will enable businesses to anticipate and counter currency risks in time.
Work with financial experts
When trying to analyze financial markets and currency rates, it is essential to have a dedicated team of experts who can analyze Forex markets using both fundamental and technical analysis tools. Working with financial experts, such as risk advisors or international banking specialists, and including them in your risk department is essential for large companies. Smaller companies who face currency risks can outsource these tasks to outside companies that specialize in currency markets
