When the UK narrowly voted to leave the EU on 23 June 2016, it sent shockwaves through the international community.

But while, over five years later, we’re still dealing with the political and economic fallout, there was an upside for UK businesses who traded internationally. At least in the short term.

Immediately following the referendum result, the British Pound lost 10% of its value against the US Dollar and 7% of its value against the Euro.  If you were a UK business with clients in the EU who paid you in Euro — or US clients who paid you in Dollars — this meant that, when you converted your money into British Pounds, you found yourself with a tidy profit on top of your usual fees.

Of course, this cut both ways.

Foreign businesses who got paid in British Pounds and converted the money to Euro or US Dollars saw their profits take a hit. And, for some, the effect of this currency exposure was significant enough to put them out of business.

But let’s back up for a second.

What’s currency exposure?

And, more to the point, how can you keep it to a minimum?

Currency exposure is the risk of losing money due to exchange rate fluctuations. It’s also known as currency risk, or FX exposure.

Imagine you’re a Dublin-based graphic design business. One of your major clients is headquartered in London, and they pay you in British Pounds.

Because the Republic of Ireland’s official currency is the Euro, you have to convert the payment in order to file your accounts, settle your bills, and pay for day-to-day expenses like food and rent.

As a result, you have currency exposure.

Let’s say the client owes you £2,000 and the invoice is due in 30 days.

Right now, the GBP/EUR exchange rate is 1.17, which means the £2,000 is worth €2,340.

But if the Pound weakens against the Euro before you’re paid, you could find yourself with less than the €2,340 you were expecting when you make the conversion.

In this example, currency exposure arises in the context of a business transaction. But the risk is there whenever you need to exchange currency.

Imagine you’re at home in Basingstoke and a mate who is stranded in Florence asks you to spot them some cash.

Any fluctuations in the GBP/EUR exchange rate between the time you send the money and the time they receive it could result in your mate getting less than they asked for. Or in you paying more than you anticipated.

Similarly, if you’re UK-based but invest on the New York stock exchange, any fluctuations in the GBP/USD exchange rate could negatively affect the value of your portfolio.

While currency exposure arises whenever there’s a foreign exchange element, it creates three different types of risk for businesses:

• Transaction risk
• Translation risk
• Economic risk

Let’s take a deep dive into each risk.

Transaction risk arises whenever a transaction involves foreign currency. This could be an invoice payment or even salary payments to employees based abroad.

In both cases, if the exchange rate moves in the wrong direction, you either get less money than you originally thought you would or — in the case of payroll, for instance — you could end up paying more than you budgeted.

Either way, it’s harder for you to plan ahead and it hurts your bottom line.

Transaction risk is the most common type of currency exposure. But limiting its effects is also relatively straightforward. You can usually do this by putting a hedging strategy in place.

Hedging is the foreign exchange equivalent of insurance. Just as car insurance covers your expenses if you’re in a road accident — and health insurance ensures you can afford care if you get sick —  hedging limits your exposure when the exchange rate moves in an unfavourable direction.

You can hedge against transaction risk in two main ways:

• Diversification. This means spreading your risk. Imagine you’re a UK business that has employees in France and Poland. A diversification strategy could involve you holding some Euro and some Zlotys in reserve.So, if the exchange rate is unfavourable, you can use this money instead of exchanging Pounds for Euro or Zlotys at a bad rate.  You could also diversify further by holding some money in US Dollars. That way, if the Pound’s exchange rate is unfavourable and your reserves aren’t enough, you can exchange US Dollars instead of taking the hit.
• Derivatives help you limit risk by allowing you to lock in a better rate. There are two main types you can use to hedge transaction risk:
  • Options. These are contracts which give you the right — but not the obligation —to exchange one currency for another at a fixed rate in exchange for a fee.
    This gives you a choice. If you need to exchange Pounds for Euro, for instance, but the exchange rate is bad, you can exercise your option and get a better rate
  • Forwards. Here, you’d also agree to exchange X amount of a currency at a pre-agreed rate. But, unlike options, there’s a legally binding obligation to go ahead with the transaction.

You’re exposed to translation risk if you have assets or liabilities in a foreign currency. Here, currency exchange fluctuations could increase your liabilities or lower the value of an asset.

Imagine you’re a Spanish business that has a factory in the UK. Because it’s in the UK, it’s valued in Pounds. But since you’re headquartered in Spain, you need to convert the amount to Euro for your accounts.

In 2020, your factory was worth £250,000. This was equal to around €284,000.

But, in 2021, the Euro’s value relative to the Pound went down. So, even though your property rose in value and became worth £265,000, when you convert it into Euro it’s worth €274,000 — a €10,000 loss.

The same can happen with liabilities.

Say you’re a US-based company with a subsidiary in the UK. You took out a £120,000 loan to pay for equipment.

In 2020, this worked out at around $158,400.

In 2021, you paid £10,000 off your loan. But because the US Dollar rose in value, £110,000 now works out at around $165,000, so your liabilities have increased.

One way to hedge against translation risk is to use a derivative called a swap — an exchange of debts in different currencies.

If you’re a US-based company who needs to borrow money in Pounds, you could borrow in Dollars from your local bank. You’d then exchange this loan for one in Pounds taken out by a UK company.

The idea is that the UK company can probably get a better interest rate on a loan denominated in pounds, because they’re local. Similarly, because you’re local, you can probably get a better interest rate on a US Dollar-denominated loan. So, by taking out loans locally and exchanging them, you both get a better deal.

You can also hedge against translation risk using options and futures.

Economic risk, also known as operational risk, is the potential impact of foreign exchange fluctuations on your future cash flow and, in turn, on your company’s value.

Let’s go back to our Dublin-based graphic design business.

If the Pound goes down in value against the Euro, the business won’t just lose money on individual invoices. Over time, the amount of money coming in will be less than anticipated. This may cause cash flow issues, make the company less profitable, and lower its market value.

Of the three risks, economic risk is the trickiest, because it happens over the long term.

That said, using options and forwards can help lower operational risk by locking in favourable exchange rates you can fall back on if the market exchange rate continues to evolve unfavourably over a long period of time.

They say the only two things that are certain in life are death and taxes.

But if you’re a business with foreign clients or suppliers, so is currency exposure.

Whether it’s a shock referendum result or something more subtle, like a country’s central bank lowering interest rates or higher inflation, most currencies fluctuate in value at some point. And, because of this, there’s always a risk that your bottom line might suffer.

The good news is that you don’t have to be at the mercy of the markets.

You may not be able to control what happens to exchange rates. But having a hedging strategy in place gives you something to fall back on if things don’t go your way.

Find out how one of our partners can help – powered by our technology platform.