Understanding Foreign Exchange Risk Management

Meow Technologies, Inc.

Meow Technologies, Inc.

Foreign exchange (forex) risk refers to the potential for a business to experience volatility in earnings, cash flows, or asset values due to fluctuations in foreign currency exchange rates. For companies that import or export goods, have foreign operations or subsidiaries, or deal in multiple currencies, exchange rate movements can have a significant impact on profitability. Effectively managing this forex risk is crucial for business stability and success when operating internationally.

In this post, we’ll look at the key types of foreign exchange risk, strategies and instruments businesses can use to minimize their exposure, and important accounting considerations regarding functional and reporting currencies.


Main Risks

There are three primary types of forex risk that business should be aware of:

Transaction Risk

Transaction risk refers to the exchange rate risk that occurs when there is a time lag between a firm agreeing to a transaction that involves foreign currency and when that transaction settles. For example, if a Canadian importer purchases machinery from a European supplier for €1 million, and the Euro depreciates 10% against the Canadian Dollar in the month between placing the order and making payment, the importer will face higher costs.

The greater the time delay between a transaction and settlement, the higher the transaction risk. Common transactions exposed to exchange rate fluctuations include:

  • Export sales and importer purchases
  • Overseas debt repayment
  • Foreign subsidiary funding/capital transfers
  • Contract obligations denominated in foreign currency
  • Repatriation of overseas profits or dividends

Economic Risk

Economic risk describes the risk that unexpected currency movements negatively impact the present value of a company’s future foreign cash flows or assets/liabilities.


For example, if a U.S. manufacturer exports heavily to Europe and holds future Euro-denominated accounts receivables on its balance sheet, a strengthening of the U.S. Dollar would decrease the expected Dollar value of these assets.


Economic risk can also influence competitiveness – for instance, a dramatic currency swing that causes imported goods to suddenly become cheaper could undermine domestic businesses reliant on local sales.

Translation Risk

Translation risk occurs when multinational corporations translate foreign subsidiary financial statements into their consolidated reporting currency – typically USD for U.S. firms.

If the local currency depreciates substantially against the reporting currency, it would significantly reduce the value of the foreign operation’s earnings and net assets when translated, which directly hits the consolidated financial statements.

Firms with a higher percentage of foreign assets and earnings face greater translation risk exposure.

Key Risk Management Strategies

Businesses have several major mechanisms available to reduce or hedge their foreign exchange risk, including:


Price in Home Currency

Invoicing foreign sales and purchases in the home currency transfers the exchange rate risk to buyers/suppliers and protects the firm’s revenues and costs. However, competitors may offer pricing in local currency, and buyers could struggle with sudden swings in their obligations.


Currency Hedging Instruments

Derivatives can be used to lock in or guarantee a foreign exchange rate and provide certainty. Common hedging instruments include:

  • Forwards – Contract to buy/sell currency on a future date at a set exchange rate. Useful for hedging transaction risk.
  • Futures – Similar to forwards but on a standardized contract traded on an exchange.
  • Options – Provides the right but not the obligation to buy/sell currency at a preset rate. Allows participation in favorable moves.
  • Swaps – Involves exchanging cash flows for one currency with another to manage long-term currency risk. Popular for economic risk.

Cash Flow Hedging

Cash flow hedging directly hedges the exchange rate risk associated with highly probable future transactions and cash flows in foreign currencies. It utilizes derivatives to lock in the functional currency cash flows, allowing businesses to preserve margins and manage volatility.

Balance Sheet Hedging

A balance sheet hedge involves using financial instruments to protect the value of existing balance sheet items denominated in a foreign currency, such as payables, receivables, debt, and subsidiary assets/liabilities. Hedging instruments are marked-to-market, with gains/losses offsetting spot exchange movements on the underlying exposure.

Accounting Considerations

As cash flow hedging relates to forecasted transactions while balance sheet hedging deals with existing balance sheet items, the accounting treatment differs significantly:

Hedge Accounting

Special hedge accounting principles apply for cash flow hedging relationships to minimize income statement volatility. The effective portion of gains/losses on the hedging instrument are recorded in equity via Other Comprehensive Income – they are only recognized in earnings when the hedged transaction impacts profit/loss. In contrast, balance sheet hedging gains/losses appear directly in current period earnings.

Functional vs Reporting Currency

Multinationals can face complex accounting requirements around whether foreign currency risk stems from transaction, translation, or economic exposure. Careful assessment of the functional currencies of foreign subsidiaries relative to the reporting currency of the consolidated entity is key.


Other Opportunities

While cash flow and balance sheet hedging are most common, businesses can also consider:

Net Investment Hedging – Hedging the currency risk associated with subsidiary foreign equity investments.

Earnings Translation Hedging – Although no hedge accounting, options could hedge earnings translation risk.

M&A Hedging – Deal completion uncertainty makes M&A hedging complex, but currency volatility merits consideration.

The specific hedging objectives, accounting implications, subsidiary translations, regulations, tax laws, and business context require thorough evaluation ahead of implementing a currency risk management strategy. Consultation with treasury, accounting, legal, and banking advisors is advised.

Conclusion

This post has covered the fundamentals of foreign exchange risk and outlined key hedging strategies available for importers, exporters, and multinational corporations. Managing forex exposures is crucial for companies engaged globally across borders. We hope this overview provides a useful introduction to evaluating and mitigating currency volatility. Reach out if you have any other questions on protecting your business from exchange rate risk.


Meow Technologies is a financial technology company, not a bank or FDIC-depository insured institution. Likewise, Meow Technologies is not an investment adviser and none of the information presented herein should be relied upon as financial advice or a recommendation to make any financial decision nor should it be considered to be tax or legal advice. The information is the opinion of Meow Technologies for educational purposes and may not be suitable for all companies. Products, like the one described herein, are offered through Meow Technologies and are not advisory services which are only offered through Meow Advisory, LLC.** The FDICs deposit insurance coverage only protects against the failure of an FDIC-insured bank.**

Get started with Meow

*Disclaimer: Meow Advisory LLC is a registered investment adviser. Registration as an investment adviser does not imply any level of skill or training.
For accounts opened through Atomic Brokerage LLC: Meow Advisory LLC has an engagement with Atomic Brokerage LLC (“Atomic Brokerage”), a registered broker-dealer and member of FINRA and SIPC , to bring you the opportunity to open a brokerage account. Brokerage services for customers of Meow Advisory LLC are provided by Atomic Brokerage. For more details about Atomic Brokerage, please see the Form CRS, General Disclosures, and the Privacy Policy. Check the background of Atomic Brokerage on FINRA’s BrokerCheck.
For subadvisory services for accounts opened through Atomic Invest LLC: Meow Advisory LLC has an engagement with Atomic Invest, LLC (“Atomic Invest”), an SEC-registered investment adviser, to bring you the opportunity to open an investment advisory account. Investment advisory services are provided by Atomic Invest. Companies which are engaged by Atomic Invest receive compensation of 0% to 0.85% annualized, payable monthly, based upon assets under management for each referred client who establishes an account with Atomic Invest (i.e., exact payment will differ). Atomic Invest also shares a percentage of compensation received from margin interest and free cash interest earned by customers with Meow Advisory LLC. Meow Advisory LLC is not a client of Atomic Invest, but our engagement with Atomic invest gives us an incentive to refer you to Atomic Invest instead of another investment adviser. This conflict of interest affects our ability to provide you with unbiased, objective information about the services of Atomic Invest. This could mean that the services of another investment adviser with whom we are not engaged could be more appropriate for you than Atomic invest. Advisory services through Atomic Invest are designed to assist clients in achieving a favorable outcome in their investment portfolio. They are not intended to provide tax advice or financial planning with respect to every aspect of a client’s financial situation and do not include investments that clients may hold outside of Atomic Invest. For more details about Atomic Invest, please see the Form CRS, Form ADV Part 2A, the Privacy Policy, and other disclosures. Brokerage services for Atomic Invest are provided by Pershing Advisor Solutions LLC (“PAS”), a registered broker-dealer and member of FINRA and SIPC.
Neither Atomic Invest nor Atomic Brokerage, nor any of their affiliates, is a bank. Investments in securities are Not FDIC insured, Not Bank Guaranteed, and May Lose Value. Investing involves risk, including the possible loss of principal. Before investing, consider your investment objectives and the fees and expenses charged by Atomic Brokerage and/or Atomic Invest.
See the Legal Section within the Meow website for additional agreements.

U.K. Gilt pricing quoted net of fees. ~5% U.K. Gilt yield is sourced from Investing.com December 2023 6-month United Kingdom 6-Month Bond Yield. ~5% Treasury Bill yield is sourced from treasurydirect.gov December 2023 12-week U.S. Treasury Bill auction.

**Disclaimer: Meow Technologies is a financial technology company, not a depository, bank or credit union, and your account at Meow is not, itself, an FDIC-insured product.

Meow currently partners with three banking providers. Banking services are provided by Third Coast Bank SSB; Member FDIC, Grasshopper Bank, N.A; Member FDIC, and FirstBank, a Tennessee corporation; Member FDIC.

By opening a Maximum Checking account through Meow and if you choose to receive banking services provided by Grasshopper Bank, N.A, you deposit your funds into a deposit account at Grasshopper Bank, N.A. which sweeps those funds into deposit accounts across a network of Federal Deposit Insurance Corporation (“FDIC”)-insured banks, for up to the current standard maximum deposit insurance amount (“SMDIA”) of $250,000 per eligible depositor, per destination institution, for each ownership capacity or category, subject to applicable terms and conditions, including Grasshopper's ICS Deposit Placement Agreement. Grasshopper Bank, N.A. uses a third-party vendor and agent to help administer this sweep process. Visit https://www.intrafi.com/network-banks/ for a list of the banks and savings associations with which we/Grasshopper, N.A. have a business relationship for the placement of deposits at destination institutions, and into which your deposits may be placed (subject to applicable terms with you, and any opt-outs by Grasshopper, N.A. or you). The current maximum deposit insurance amount for your funds is up to $125 million in FDIC insurance through the sweep network of Grasshopper Bank, N.A, subject to change at any time with notice from Meow and/or pursuant to applicable law. Terms and restrictions apply. Subject to applicable rate sheet. Interest rate on checking products quoted in Annual Percentage Yield (APY). Interest rates and yields are effective as per the date on the applicable rate sheet. See applicable terms and restrictions and refer to the applicable rate sheets for additional information.

By opening a Maximum Checking account through Meow and if you choose to receive banking services provided by Third Coast Bank SSB, you deposit your funds into a deposit account at Third Coast Bank SSB. If you also hold funds in a sweep program with Third Coast Bank SSB, Third Coast Bank SSB sweeps those funds into deposit accounts across a network of FDIC-insured banks, for up to the current SMDIA of $250,000 per eligible depositor, per receiving bank, for each ownership capacity or category, including any other balances you may hold at that receiving bank directly or indirectly through other intermediaries, including broker-dealers. Third Coast Bank SSB uses a third-party vendor and agent to help administer this sweep process. Visit Third Coast Bank SSB for a list of the banks and savings associations with which we/Third Coast Bank SSB have a business relationship for the placement of deposits at receiving banks, and into which your deposits may be placed (subject to applicable terms with you, and any opt-outs by Third Coast Bank or you). The current maximum deposit insurance amount for your funds is up to $50 Million in FDIC insurance through the sweep network of Third Coast Bank, subject to change at any time with notice from Meow and/or pursuant to applicable law. Terms and restrictions apply. Subject to applicable rate sheet. Interest rate on checking products quoted in Annual Percentage Yield (APY). Interest rates and yields are effective as per the date on the applicable rate sheet. See applicable terms and conditions and refer to the applicable rate sheet for additional information.

By opening a Maximum Checking account through Meow and if you choose to receive banking services provided by FirstBank, a Tennessee corporation, you deposit your funds into a deposit account at FirstBank, which sweeps those funds into deposit accounts across a network of FDIC-insured banks, for up to the current SMDIA of $250,000 per eligible depositor, per destination institution, for each ownership capacity or category, subject to applicable terms and conditions, including FirstBank's ICS Deposit Placement Agreement. FirstBank uses a third-party vendor and agent to help administer this sweep process. Visit IntraFi for a list of the banks and savings associations with which FirstBank has a business relationship for the placement of deposits at destination institutions, and into which your deposits may be placed (subject to applicable terms with you, and any opt-outs by FirstBank or you). The current maximum deposit insurance amount for your funds is up to $125 million in FDIC insurance through the sweep network of FirstBank, subject to change at any time with notice from Meow and/or pursuant to applicable law. Terms and restrictions apply. Subject to applicable rate sheet. Interest rate on checking products quoted in Annual Percentage Yield (APY). Interest rates and yields are effective as per the date on the applicable rate sheet. See applicable terms and restrictions and refer to the applicable rate sheet for additional information.

***FDIC insurance coverage is only available to protect you against the failure of an FDIC-insured bank that holds your deposits (and does not protect you against the failure of Meow or other third party). Your account with Meow and all services provided to you are subject to the Meow Terms of Service (“Account Agreements”) and other applicable terms and no other representations or warranties, express or implied, are provided to you except as expressly set forth in those written Account Agreements. If you have any questions regarding your account, please contact team@meow.com.

FirstBank Funds Availability Notice

FirstBanks general policy is to allow you to withdraw funds deposited in your account on the first business day after the day we receive your deposit. Funds from electronic deposits will be available on the day we receive the deposit. In some cases, we may delay your ability to withdraw funds beyond the first business day. Then, the funds will generally be available by the SECOND business day after the day of deposit.