In my work, I’ve seen foreign exchange (FX) risk impact businesses of all sizes—from a small firm buying parts from outside its main business currency area to a multi-billion dollar fintech like Wise. It’s a common misconception that FX risk only matters to large, multinational corporations and that it’s an “accounting thing”. The truth is, if your business buys or sells across currencies, you’re exposed. When left unmanaged, a gain or loss can seemingly “magically” appear on your financial reports without any real understanding of how it affects your outcome, pricing, or taxes.
This brings us to a fundamental question: what exactly is FX risk, and why should you care?
Beyond the Bottom Line: Unpacking the Different Types of FX Risk
My biggest learning from my five years at Wise was that FX risk is not a single, monolithic problem. It can be viewed from several different angles, and not all of them cause a direct loss in cash.
For example, while a treasury team might track FX risk until a payment is settled, accounting might need to track it until the business transaction is fully completed according to IFRS. This creates a fascinating and sometimes challenging overlap, with different teams measuring the same risk in different ways and eventually resulting in different impact outcomes.
Generally, FX risk can be broken down into three main categories:
Transaction Risk: This is the most common and easiest to understand. It’s the risk that an exchange rate will change between the time a transaction is initiated (e.g., an invoice is created) and when it’s settled (the payment is received or sent). The difference in the exchange rate results in a tangible gain or loss on your balance sheet (and in cash!).
Economic Risk: This risk, also known as operating risk, is the potential impact of exchange rate changes on your business’s future profitability and cash flow. For a manufacturing company, a stronger foreign currency could make your imports more expensive, impacting your profit margins in the long run.
Translation Risk: This risk arises when you consolidate the financial statements of foreign subsidiaries into a single reporting currency. The gains and losses here are often non-cash, but they can still create significant volatility in your group’s overall financial statements, which impacts how investors and stakeholders view your performance or you yourself interpret the financial results.
The Power of Seeing the Whole Picture
The magnitude of FX risk depends on several factors: your base currency, the foreign currencies you do business with, the amount of the business (trade), and the volatility of the currency pair.
Also it’s crucial to think of FX throughout the trade cycle (ie from purchase to goods/service delivery or pay-in to payout delivered).
The key insight I’ve gained is that understanding these factors isn’t just about avoiding a loss—it’s about finding opportunities to mitigate various risks.
Whether you’re a small business or a large corporation, the tools for mitigating FX risk are available to everyone. You can:
Hedge Externally: Use financial instruments like forwards or options to lock in a future exchange rate. This is similar to how large production companies buy energy futures to keep their energy costs stable during volatile markets.
Hedge Internally: Use smart business practices to offset FX risk, like matching foreign currency assets with foreign currency liabilities.
Make Smart Decisions: A manager’s decision to weigh options, like paying extra interest on a foreign debt one month versus an early repayment that could expose them to a massive rate loss, is a classic example of managing this risk.
My journey has taught me to think risk & control, do the math, see patterns, and understand the big picture. It gave me the opportunity to build tools for monitoring FX exposure and work closely with teams who can act on the insights to mitigate risk.
A Quick Thought Before We Continue
Smaller, more conventional businesses have a lot to learn from modern companies like Wise. It all starts with the simple, but crucial, act of seeing and understanding the magnitude of your exposure and beginning to track it. You can learn to manage this yourself or involve experts with theoretical and practical knowledge, but the first step is always to get the full picture.
In our next blog post, we’ll dive into the specifics of how to do just that: How to Record and Calculate Foreign Exchange Exposure.