Your guide to exchange rate risk and mitigation
Note: this article does not constitute business advice. Please seek a certified consultant and exercise judgement for professional guidance.
After two years of bullish growth, recent inflation and interest rate hikes have triggered the current economic slowdown, causing widespread financial upheaval. Its effects are spreading across borders and industries and may be long-lasting, and experts agree that a recession in the near future is possible.
Given how tightly-interconnected the modern economy is, recessions can affect the foreign exchange market and exacerbate any currency-related risks a business is already facing. Hence, keeping an eye on exchange rate fluctuations and understanding the underlying risks are important for a company’s financial wellbeing. In this guide, we’ll outline the risks associated with exchange rate fluctuations and illustrate how you can protect your business.
What a recession means for businesses
A recession is a significant and long-term decline in economic activity, in which a country’s national economy may experience negative gross domestic product (GDP), rising unemployment, a fall in retail sales, and a drop in consumer spending.
Recessions are often regarded as an unpleasant but unavoidable part of an economic cycle. Right now, analysts are expecting a prolonged recession as central banks hike up interest rates to offset rampant inflation. Here are some reasons why recessions happen:
If commodity prices keep rising for a long time, central banks need to raise interest rates to offset the inflationary pressure. When this happens, the economy may experience turbulence as borrowing money becomes more expensive, which may then trigger a recession.
A sudden economic problem can cause considerable damage. For example, an abrupt disruption in supplies of commodities like oil and food, or unexpected events like the COVID-19 pandemic can stall or even shut down markets globally.
Bursting asset bubbles
When the economy is robust, investors can be overly optimistic about investing. This emotion-driven enthusiasm will pose a problem if the economy takes a downturn. The mass panic-selling that follows suit may drag the market into a recession.
Understanding exchange rate risks
However, it might be reassuring to know that recessions don’t last forever. If you take the right measures, you could mitigate the adverse effects and make the most of the subsequent economic rebound once the recession ends.
One key aspect for multinational businesses is to understand exchange rate risk - the various risks companies are exposed to when exchanging currencies, such as engaging with parties or customers that use foreign currencies. This is because the need to convert foreign and domestic currencies means businesses’ bottom lines are exposed to exchange rate fluctuations.
Generally, there are three types of exchange rate risks:
The first is transaction exposure. This refers to the exchange rate fluctuation between when the trade is made and when it is executed. If that foreign currency appreciates, the buyer may incur losses, and vice versa.
For example: An Australian company buys precious metals in Australia at AUD 100,000 and sells them abroad for USD 70,000 with the AUD/USD exchange rate at 0.6363. Initially, the company is projected to earn AUD 10,000 (USD70,000/0.6363 - AUD 100,000 = AUD 10,000) with the said exchange rate.
However, within the two-month period before making the deal and receiving the payment, the USD weakened and the rate rose to 0.6603. The company only makes AUD 6,000 of profit as a result (USD 70,000/0,6603 - AUD 100,000 = AUD 6,000).
The second is economic exposure. During unexpected currency fluctuations, a company’s market value may be affected by changes in operating costs and earnings. This usually comes from changing economic and political conditions and may take time to recover from.
For example: a Lithuanian sports equipment company may face risks if the Eurozone experiences economic turbulence or if one of the manufacturer’s home countries descends into political turmoil.
The third is translation exposure. When a company’s assets, liabilities or cash flows are in the domestic currency, but operations are conducted abroad, its value could be “translated” downwards if there is exchange rate volatility.
For example: A Singaporean company that organises its assets in SGD but has extensive dealings in China may suffer from translation exposure if it converts its earnings in CNY to SGD and there is a sudden disturbance to the exchange rate.
Ways to mitigate exchange rate risks
One less-discussed aspect of today’s business world is that companies don’t even need to sell abroad to feel the effects. From raw materials procurement and operational costs to payments to vendors and liquid assets like cash, every component of multinational business is exposed to exchange rate fluctuation.
Also, exchange rates may shake up the prices of commodities and affect consumers’ spending power. The exchange rate freefall in Japan has pushed the economic powerhouse to a questionable economic state. Consumers have struggled to maintain their purchasing power amid a stagnant economy and significantly weakened yen, meaning companies doing business in Japan can be affected.
There are a few ways in which you can reduce the effects of volatile exchange rates and better prepare your business to be more recession-proof. For example, you can spread the risk by diversifying your markets, operations, and vendors to different currency jurisdictions. Also, include a clause when you negotiate contracts about sharing the risk from the exchange rate fluctuations, such as using mid-market rate or adjustments measures if the volatility reaches a certain level. Furthermore, you can book a foreign exchange forward contract with an FX provider like Currenxie and lock a rate up until an agreed date in the future to better offset the effects of currency fluctuations.
A payment platform that can let you move money between currencies in a simple and transparent way is key to staying flexible. At Currenxie, we support rapid or real-time transfers in over 20 currencies and provide real mid-market FX rates without hidden fees. We also have one of the world’s largest virtual bank account networks, enabling you to collect cross-border payments with ease.
We are here to give you peace of mind as you navigate the multinational business world during calm and turbulent times. Sign up for your Currenxie Global Account and keep your risks at bay.