How to mitigate foreign exchange risk
When making international payments in a foreign currency, there’s a risk of losing money due to fluctuations in the exchange rate. If your business relies on currency exchange and making international payments, it’s important to understand how to mitigate foreign exchange risk to protect your business against financial losses.
In this article, we cover:
- What is foreign exchange risk?
- How to reduce foreign exchange risk
- Forward contracts
- FX market orders
- Limit orders
- Stop-loss orders
- OCO orders
What is foreign exchange risk?
Foreign exchange risk, also known as FX risk, exchange rate risk, or currency risk, typically applies to importers and exporters, or businesses that require currency exchange and international payments. Companies wishing to buy or sell a currency to settle an international invoice do so by locking in an exchange rate to buy a predetermined currency and amount for a future date. However, with the financial markets offering exchange rates on a real-time basis it is a challenge to lock in an exchange rate that matches your pre-costed pricing.’
If a country’s currency has depreciated in value, its goods and services will be cheaper for buyers overseas. If the currency has appreciated in value, those prices will be more expensive for international buyers. So, what can you do to mitigate foreign exchange risk?
How to reduce foreign exchange risk
There are several different FX risk management strategies available to organisations looking to make the most of their foreign currency exposure. Also known as ‘currency hedging’, these strategies offer protection from currency volatility potentially resulting in a loss by fixing the exchange rate to a known quantity. When done properly, it can offset any losses to create more consistency in currency exchange budgeting.
Let’s look at some examples of how to reduce foreign exchange risk using hedging products.
A forward contract is a way of insuring against foreign exchange risk. It’s a legally binding agreement to carry out a predetermined currency exchange on a certain date in the future.
The forward contract will specify the exchange of a sum of money at a fixed exchange rate for up to two years in the future This allows businesses to budget effectively, by giving them certainty that their costs to exchange currency are known in advance and will be unaffected by future exchange rate movements.
FX market orders
Foreign exchange or an FX order is an instruction to buy or sell currency at a pre-defined target exchange rate. FX orders are used by businesses to protect or maximise the exchange rate and the underlying value of the FX trade.
There are three types of FX orders, which can be leveraged as part of your currency risk management strategy. Let’s look at them in more detail.
A limit order is an instruction to buy or sell currency at a rate of exchange that is higher than the current exchange rate. If that exchange rate is achieved, currencies are automatically exchanged.
A stop-loss order is essentially the opposite of a limit order and is useful when there is a risk that the exchange rate may become less favourable. It instructs the exchange of currency once a certain price is reached and prevents the buyer from losing money on the purchase.
A one-cancels-the-other or OCO order combines a limit order with a stop-loss order. The buyer can specify a limit level above the current exchange rate, along with a stop-loss order below it. If the exchange rate reaches either the higher or lower order, the exchange of currency will automatically be made. This allows businesses to benefit from positive exchange rates while also avoiding any negative impacts of unfavourable rates.
Whatever industry you’re in, if your business conducts cross-border transactions, Halo Financial can help you with insuring against foreign exchange risk. Register for a free account with us today to benefit from less risk and more profit.