What are the Three Types of Currency Risk?

Only a few days ago the Bank of England finally announced, after heated and close discussions, that the current 5.25% interest rate will be kept as is, though it comes with a promise to look at potential cuts come August.

UK’s businesses are still navigating post-Brexit and trying to find and strengthen their global trade footprint again. With fluctuations of the British pound, the upcoming snap election, and several ongoing economic uncertainties, the vulnerability of companies to exchange rate movements becomes clearer again.

Businesses of all sizes are exposed to a constant ebb and flow of forex markets. Currency fluctuations can significantly impact your bottom line, so understanding and managing currency risk is fundamental for sustainable success in international operations. Looking at international trade, there are three main types of currency risk that businesses can encounter and need to be aware of.

Transaction Risk

The most common type of currency risk. It arises when goods or services are bought or sold in a foreign currency. If the currency weakens against the pound before the invoice is paid, businesses will end up spending more pounds to cover the cost. Transaction risk, especially for those businesses with frequent international transactions, impacts cash flow and can potentially squeeze profit margins.

To mitigate those risks, forward contracts can lock in exchange rates for future transactions, providing certainty and protection from fluctuations. Spot contracts allow for immediate exchange at the current market rate and are suitable for smaller transactions or situations where some level of rate volatility is acceptable. Lastly, currency options offer the right (but not the obligation) to buy or sell a currency at a predetermined rate by a specific date, which provides flexibility and potential for gains if the market moves in the business’s favour.

Translation Risk

This second type of risk pertains to the impact of currency fluctuations on financial statements. If the company has subsidiaries operating in countries with different currencies, changes in exchange rates can distort the reported value of its assets, liabilities, and equity when consolidated into a single financial report. As this can affect the business’s financial ratios (e.g. debt-to-equity), it can potentially mislead investors or creditors about its true financial health.

By designating a single functional currency for each foreign subsidiary based on its economic environment, the impact of those fluctuations on consolidated financial statements can be minimised. Alternatively, similar to transaction risk mitigation, businesses can consider forward contracts or options for currency hedging against anticipated movements in currencies that are relevant to the specific subsidiaries.

Economic Risk

This way broader risk refers to the potential impact of currency fluctuations on the overall business environment. A strong British pound can make your exports less competitive in foreign markets, as the goods become relatively more expensive. Conversely, a weakening pound can increase import costs, impacting production margins. Economic risk necessitates a more holistic view of how currency movements influence the industry, supply chain, and target markets of a business.

Economic risk can be mitigated by diversification. By spreading the customer base and supplier network across different currencies, dependency on any one of them will be reduced. It’s also smart to have a dynamic pricing strategy at hand, which implements flexible pricing models that can easily be adjusted based on currency fluctuations. In the end, it falls into monitoring the movements and reacting proactively.

Incorporating currency risk considerations should always be a part of long-term business strategies. Understanding the different types and ways to handle them is vital when engaging in international trade. Proactive management of these risks can help maintain financial stability and competitive advantage.

For further reading on the impact of currency fluctuations and recent developments in the UK economy, we recommend regularly visiting the Bank of England and Financial Times websites.