Skip to content

Fundamentals

FX Risk is the uncertainty of financial loss caused by changes in the exchange rate, that is, the risk that the financial result of a future operation will be different from what was planned because the currency price changed.

Note that although FX risk is related to the financial aspect of the institution, it impacts the entire strategic planning of corporations.

Volatility

The main source of FX risk is volatility, which is the measure of the intensity and frequency with which the price of an asset (in this case, the exchange rate) rises and falls over a given period—usually rapidly, sharply, and significantly. Obviously, the higher the volatility, the greater the inherent risk of the asset in question.

The main consequences of a scenario of high exchange rate volatility are:

  • Destroys predictability: Prevents corporate planning for all operations involving the FX context.
  • Increases the cost of protection (hedge): Costs to use hedge instruments become more expensive.
  • Drives away investors: Less predictable environments can lead to capital flight from the country by foreign investors.

Remember, while a high or low dollar has its winners and losers, high volatility is detrimental to the economy as a whole, as it creates an environment of uncertainty that hinders business and long-term investments.

FX Exposure

FX exposure is the extent to which a company's finances (e.g., cash flows) are vulnerable to exchange rate fluctuations. Any company (or individual) that has revenue, expenses, or investments in foreign currency has some level of FX exposure.

Exposure vs Risk

It is common to confuse FX exposure with FX risk, but the difference is very simple. Exposure is the fact of having assets and values in foreign currency, while FX risk is the possibility of financial loss due to this exposure.

Case Study

"Cafés do Sul Ltda.", a Brazilian company, closes a large contract to sell coffee beans to a coffee shop chain in Europe:

  • Contract Value: €500,000 (five hundred thousand euros)
  • Payment Condition: The European client will pay the invoice in 60 days.
  • Euro exchange rate on the contract day: R$ 5.60
  • Revenue projection: All its cost, expense, and profit margin planning was based on the projected revenue of R$ 2,800,000 (500,000 x 5.60).

Note that from the signing of the contract until the day the money is received, the exporter has an FX exposure of €500,000 and its main risk is the fall of the Euro.

Scenario A: The Risk Materializes (Euro Falls)

  • On the payment date, due to economic factors, the Euro falls to R$ 5.30.
  • The company receives the €500,000 and, when converting them to Reais, obtains R$ 2,650,000.
  • Financial Impact: The company had a loss of R$ 150,000 compared to its initial projection.

Scenario B: An Unexpected Gain (Euro Rises)

  • On the payment date, the Euro rises to R$ 5.80.
  • When converting the €500,000, the company receives R$ 2,900,000.
  • Financial Impact: The company had a gain of R$ 100,000 compared to what was planned.

Conclusion

Although scenario B seems great for the company, both scenarios show the central problem related to FX risk: uncertainty. It is to eliminate uncertainty that companies resort to derivatives for FX hedging in the next section.