Businesses: 7 key questions to assess your exposure to foreign exchange risk

Are you involved in foreign exchange transactions?

If any of your revenue or expenditure is in foreign currencies, your business is exposed to foreign exchange risk.

The question then is what the ratio is between your transactions in foreign currencies and those in the domestic currency. All other things being equal, the higher the proportion of transactions carried out in foreign currencies, the greater your exposure to foreign exchange risk.

Please note that it is possible to be exposed to economic foreign exchange risk even if 100% of your transactions are conducted in the domestic currency. The prices of some of your raw materials may indeed be directly affected by fluctuations in the foreign exchange market (for example, the price of fuel, which is traded and denominated in dollars on the international market but settled in domestic currency on a day-to-day basis).

Whatever your company’s situation, a careful review of your pricing structure is therefore necessary to gain a detailed understanding of the direct and indirect impacts of exchange rate fluctuations.

Do your foreign exchange transactions offset each other?

Whilst conducting transactions in foreign currencies exposes your business to foreign exchange risk, in some cases, several of your transactions may offset one another and naturally neutralise the risk.

When analysing your business’s risk exposure, you should therefore think in terms of net position (rather than cumulative position) for each of the foreign currencies used in your business.

Good to know: Although different, certain international currencies may naturally offset one another due to political decisions or economic factors. But be careful: such links can sometimes be abruptly severed, as was the case, for example, with the end of the SNB’s EUR/CHF exchange rate floor in 2015.

Have you put a hedging strategy in place?

In addition to ‘natural’ hedges that can offset exposure to currency risk, your company can also use ‘artificial’ hedges, such as purchasing financial hedging instruments.

Hedging strategies to reduce foreign exchange risk can be partial or comprehensive, with the aim of offsetting almost all of the risk. If your company uses such strategies, you can carry out prospective (ex-ante) or retrospective (ex-post) effectiveness tests to assess their usefulness; such tests are, in fact, encouraged by International Financial Reporting Standards (IFRS).

Are your profit margins low, moderate or high?

All other things being equal, the impact of fluctuations in the foreign exchange market will vary depending on the level of your business’s margins.

Indeed, if your margins are low, they will be quickly affected by changes in exchange rates, leaving you particularly vulnerable. Conversely, the higher your margins, the more leeway you have to weather rises and falls in the FOREX market more easily.

Are the foreign currencies in question volatile?

The Turkish lira, the Argentine peso, the Russian rouble… Certain currencies described as “exotic currencies” are, on average, far more volatile than other, more stable currencies such as the euro, the US dollar or the yen, largely due to political and/or economic instability in the regions concerned.

The greater the proportion of “exotic” foreign currencies in your business, the more exposed your company will be. But be careful: still waters run deep, as even the most established currencies can experience sudden spikes in volatility!

Do you have any assets or liabilities denominated in foreign currencies?

Whilst economic and transactional currency risks are most frequently cited due to their direct impact on corporate profitability, your company may also be exposed to balance sheet risk when it holds assets or liabilities denominated in foreign currencies on its balance sheet.

And with good reason: due to exchange rate fluctuations, a foreign currency investment can suddenly fall in value, whilst a foreign currency debt can suddenly rise.

Good to know: Just as with transactions, it is also worth considering your net position here, as your asset and liability exposures may offset each other.

Do you have any subsidiaries abroad?

Finally, if your company has subsidiaries abroad, it may be exposed to foreign exchange risk when repatriating the profits generated by the subsidiary, as foreign currencies are converted into the domestic currency.

The existence of one or more subsidiaries located outside your currency zone therefore also exposes you to foreign exchange risk.

Currency risk can take many forms, and ultimately it affects us all in our daily lives. We hope that the questions and answers in this article will give you a more comprehensive and accurate understanding of your exposure!