In foreign exchange transactions, exposure is the risk that you could lose money due to the exchange rate evolving in a way that is unfavourable to you.
Imagine you’re a business in Edinburgh that has bought goods worth €2,500 from a supplier in Barcelona. Payment is due one month after delivery.
At the time you make the order, the GBP/EUR exchange rate is 1.15. This means it costs £1 to buy €1.15, so the cost in British Pounds of the goods you’ve bought is £2,173.
But because exchange rates fluctuate, there’s a chance that the GBP/EUR exchange rate could go down by the time payment to your supplier falls due. If this happens, you’ll need more British Pounds to buy the same amount of Euro, which means you’ll pay more for your goods than the £2,173 you originally budgeted.
The risk that the exchange rate will go up and make your goods more expensive in your home currency is called exposure.
The exposure in our example is called ‘transaction exposure’, because it arises from an international trade transaction paid in a foreign currency. Transaction exposure increases the longer there is between the sales agreement and the date at which payment falls due. This is because there’s more time for the exchange rate to fluctuate.
Your business may also face two other types of foreign exchange exposure:
- Operating exposure
- Translation exposure
Operating exposure is the potential impact that exchange rate fluctuations could have on your future cash flow.
Let’s say you’re an e-commerce website based in the US, and a big chunk of your revenue comes from your sales in Switzerland. During 2021, the USD/CHF exchange rate goes down, so when you convert your income from Swiss Francs to US Dollars, it works out at less than you expected, which lowers your profit. This is your operating exposure.
By contrast, translation exposure happens when you have assets or liabilities denominated in a foreign currency.
Imagine you’re an Irish business with a warehouse in Canada. You bought the warehouse in 2015 for CAD$60,000. But because you’re headquartered in Ireland, you need to convert this to Euro on your balance sheet.
In 2015, CAD$60,000 was worth €80,000, so your balance sheet shows the value of your Canadian warehouse asset being €80,000.
In 2020, the warehouse’s value went up because of a commercial property boom in Canada, and it’s now worth CAD$75,000. Unfortunately, though, the CAD/EUR exchange rate went down. So when you convert the money into Euro, it works out at €75,000.
So, despite the fact that your warehouse is now worth more, your balance sheet will show a €5,000 loss because of the exchange rate fluctuation. This is your translation exposure.
- Operating exposure is also known as economic exposure. It’s difficult to measure and to hedge against, because it’s typically caused by sudden, unexpected currency fluctuation, and affects you in the longer term.
- While large multinationals are most at risk from operational exposure, it can affect you even if you’re a small business that only trades locally. If you’re a Dutch business and the GBP/EUR exchange rate increases, for instance, it might work out cheaper for your clients to buy from the UK instead of coming to you. Over time, this will hurt your profits.
- Transaction and translation exposure are easier to measure and easier to hedge against. Forward contracts, futures, options, and swaps are all tools you can use as insurance against potentially unfavourable exchange rate movements.
Want to know more?
- This short course walks you through the three main types of foreign currency exposure and explains some strategies you can use to mitigate your risk, including using hedging instruments.
- If you’re up for reading something more technical, this paper from the International Monetary Fund goes into much more detail, including the ways in which you can calculate different kinds of foreign exchange exposure.
“It used to be that only huge multinationals had to worry about exposure to foreign exchange fluctuations. But with international trade now commonplace, it’s a reality for SMEs too.
It goes without saying, but it can be much harder for SMEs to weather exposure. Hedging products can be a relatively low risk way of mitigating that risk and giving them the piece of mind that they have something to fall back on should exchange rates not move in their favour.”