The UK has a long tradition of exporting goods and services overseas and many companies enjoy profitable trading relations, especially within the European Union and the United States.

What is Foreign Exchange Risk?   

If you sell goods into the Euro Zone, you will have to manage two currencies – British sterling and Euros.  Your cost of sales will be denominated in British pounds but your revenues will be denominated in Euros and to crystallize your profits you will need to convert the Euros to British pounds.

When you commence the business deal, you may have decided to proceed because the prevailing exchange rates for the deal looked profitable.

For instance:
    Sales in Euros                        € 100.00
    Exchange rate £1: 1.2 Euros   £   83.33

    Cost of sales                            (70.00)

    Net profit                              £    13.33

You complete the transaction and receive €100, however when you come to change the Euros into Pounds the exchange rate has changed so your deal looks like this:

    Sales in Euros                        € 100.00
    Exchange rate £1: 1.5 Euros   £   66.66

    Cost of sales                            (70.00)

    Net loss                                £   (3.34)

The risk is that your business is never going to know what the foreign exchange rate will be at a future date and so you cannot make a reasonable projection of profitability.

Managing the Forex Risk

There are two main ways in which foreign exchange risk can be managed and they are known as hedging and netting.

• Hedging

Hedging involves entering a contract where you will buy or sell a currency at a predetermined rate at a future date.

You know from your sales contract when you will have Euros, so you can fix the date when you expect to change them.  You will also know how many Euros you are going to need to change and thanks to the hedge, you are going to know what the exchange rate will be because you have a contract to sell so many Euros for British pounds at that time.

A popular form of contract is known as a forward contract and is typically available from banks and specialist forex dealers.  More complicated but extremely popular, are interest rate swaps where a British company will exchange its debt (denominated in say US dollars) with an American company who is expecting to receive a payment in British pounds – effectively they swap debt with each other but gain debt denominated in their home currency.

There is also the issue that while the exchange rates may move against you, or depreciate, the rates may also move in your favour, or appreciate.  If you are locked into a forward contract which says you will buy or sell at a fixed exchange rate, you will not benefit from the appreciation of the currency.  By using more complicated options and derivatives, a solution can be found which allows you to take advantage of favourable currency fluctuations but protect the downside.

• Netting

Netting is an accounting solution which maintains a balance between debtors and creditors denominated in a foreign currency.  If you are owed $1,000 by customers then you match these debts by maintaining $1,000 of creditors expecting to be paid in US dollars.  Whatever the exchange rate movement you are unaffected because you never change currencies in these instances and apply receivables to pay creditors as the money comes in.