What is Foreign Exchange risk?

If you’re engaged in international business, foreign exchange or Forex (FX) risk may represent a hidden threat that could erode profits. 

While many business owners focus on operational challenges like supply chains and customer acquisition, currency fluctuations can turn profitable deals into losses overnight.

If your business imports goods, exports products, pays overseas suppliers, or receives foreign currency payments, you're exposed to FX risk—and you need a strategy to manage it.

What is FX Risk?

Foreign exchange (FX) risk, also known as currency risk, is the potential for financial loss due to fluctuations in exchange rates between currencies. 

It occurs whenever your business has financial exposure to a currency other than your base currency (pounds sterling for UK businesses).

For example, if you agree to pay €10,000 for goods today but won't pay until next month, you're taking a gamble on what the euro will be worth in pounds when payment is due. 

If the pound weakens against the euro during that time, you'll pay more in sterling than you initially budgeted. 

Conversely, if the pound strengthens, you'll pay less but this can be very challenging to predict.

FX risk exists whenever there's a time gap between agreeing to a foreign currency transaction and its completion, or when you hold assets, liabilities, or conduct ongoing operations in foreign currencies.

Why are smaller businesses vulnerable to foreign exchange risk?

Unlike large corporations with dedicated treasury teams and substantial financial reserves, smaller businesses are particularly vulnerable to currency volatility for several reasons:

Tighter profit margins

Small businesses typically operate with slimmer margins, meaning even modest currency movements can reduce profitability. 

A 5% adverse exchange rate movement might be manageable for a multinational corporation but devastating for a smaller business working on 10-15% profit margins.

Limited resources

Most businesses lack in-house FX expertise or sophisticated risk management systems, leaving them exposed to currency movements they don't monitor or understand.

Cash flow sensitivity

With less working capital to absorb shocks, unexpected currency-related costs may create serious cash flow problems for smaller businesses.

Example of foreign exchange risk

Consider this scenario: a Manchester-based business agrees to purchase €100,000 worth of materials from a German supplier, with payment due in 60 days. 

When the contract is signed, the exchange rate is £1 = €1.15 (€100,000 = £86,957). 

However, if the pound weakens to €1.10 by payment time, the same purchase now costs £90,909—an unexpected additional expense of £3,952.

For a business with annual revenues of £500,000, this represents nearly 0.8% of total turnover lost to currency movement alone.

What are the three types of foreign exchange risk? 

There are three types of foreign exchange risk that smaller businesses should be aware of:

Transaction risk

This occurs between agreeing to a foreign currency transaction and it being paid. 

It's the most immediate and common risk businesses face. 

Every time you issue an invoice in euros or agree to pay a supplier in dollars, you create transaction risk.

Translation risk

If your business has overseas subsidiaries or significant foreign currency assets, you'll face translation risk when converting foreign financial statements into pounds for reporting purposes. 

This primarily affects larger businesses with international operations.

Economic risk

This long-term risk affects your competitive position. 

If the pound strengthens significantly, your exports become more expensive for foreign buyers, potentially reducing demand. 

Conversely, a weaker pound increases the cost of imported materials.

How do smaller businesses protect themselves from Foreign exchange risk?

Smaller businesses have developed a number of strategies to cope with foreign exchange risk including: 

1. Forward contracts: lock in certainty

Forward contracts allow you to fix an exchange rate for a future transaction, eliminating uncertainty. 
If you know you'll need €50,000 in three months, you can lock in today's rate regardless of future market movements.
They are used for predictable, significant transactions (typically £5,000+).

There is often no upfront fee, but you'll get a slightly less favourable rate than the spot rate (current market price), as the profit for the broker is built into the exchange rate spread, which is the difference between the price to buy the currency and the price to sell it.

You may also be asked for some sort of security, not necessarily a cash deposit. 

However, terms vary depending on the provider.

2. Natural hedging: match your exposures

If you both receive and pay money in the same foreign currency, consider maintaining a foreign currency account. 

This allows you to naturally offset exposures without converting currencies unnecessarily.

For example, a UK importer buying from China and selling to European customers could use euro receipts to pay Chinese suppliers (if they accept euros), reducing conversion needs.

3. Invoice in sterling 

The simplest risk management strategy is shifting the currency risk to your counterpart by insisting on sterling-denominated transactions.

This only works if you have sufficient bargaining power and won't lose business by being inflexible.

4. Systematic hedging policies

This is where you establish clear, written policies for managing FX exposure by hedging. FX hedging is a risk management strategy to protect a business from financial loss due to fluctuations in foreign exchange rates.

For example:

• hedge 100% of transactions over £10,000
• hedge 75% of expected quarterly foreign currency receipts
• review and adjust hedging quarterly based on business forecasts.

Having systematic policies ensures consistent risk management.

When NOT to hedge

Hedging isn't always appropriate. For instance:

• when you have small, irregular transactions, the cost may outweigh the benefit
• if the exposures naturally offset each other
• if the timing of transactions is uncertain. Hedging works best with predictable cash flows.

Please seek specialist advice to consider which hedging option may work best for your business.

5. Technology solutions 

You may consider using FX risk management tools hosted by fintech companies.

Building your foreign exchange risk management plan

You could start with these practical steps:

1. Audit your exposure: list all foreign currency transactions over the next 12 months
2. Quantify the risk: for example, calculate how a 10% adverse currency movement would affect your business
3. Set risk tolerance: decide what level of currency loss your business can absorb
4. Choose appropriate tools: match hedging strategies to your specific needs and transaction patterns
5. Monitor and review: regularly assess your hedging effectiveness and adjust as needed.

Resources and support 

There are a number of places smaller businesses can go for help reducing foreign exchange risk.

Government support

UK Export Finance (UKEF) addresses currency risk primarily through its Local Currency Financing option, which provides guarantees for overseas buyer credit loans in the buyer's local currency, thereby shifting the currency risk from the buyer to the lender. 

However, this is subject to a suitable local partner bank being found. 

Trade bodies

The Chartered Institute of Export & International Trade also has a useful video online video about managing currency risk.

Traditional banks

Most traditional UK banks also have international trade teams.

Take away message

Foreign exchange risk management isn't about predicting currency movements—it's about protecting your business from unexpected shocks through mitigation. 

The cost of implementing basic FX risk management is typically less than the potential cost of doing nothing. 

In today's interconnected global economy, managing currency risk is increasingly becoming a business necessity.

Even small international business activities can expose a business to significant currency risks, but simple, affordable tools exist to manage that exposure effectively.