Understanding Exchange Rate Risk and Management for Startups
Starting a business? Discover how exchange rate risk impacts startups and learn essential strategies to protect your business.
The United Kingdom has a thriving ecosystem of small and medium-sized enterprises (SMEs), making it a global leader in the commercial world. However, Startup Genome reports that, like the rest of the world, the United Kingdom has a relatively high percentage of startup failure of about 60%.
Understanding exchange rate risk
The exchange rate is the amount of one currency that can be purchased with another. According to the United Nations COMTRADE database on international commerce, the UK imported around $110.33 billion in 2022 from China. If the GBP/CNY exchange rate on TradingView is 1.89, one pound sterling will buy 1.89 Chinese Yuan, and vice versa.
Several factors influence the level of the exchange rate between any two currencies. These include market interest rates, the size of each country's economy, GDP, and the unemployment rate.
Startups typically fail due to various factors, such as running out of cash, cash flow problems, industry-specific challenges and exchange rate risks. Currency exchange rate fluctuations can result in higher expenses and lower earnings.
Exchange rate risks affect not just multinational businesses that deal in foreign markets but also small and medium-sized businesses, including those that operate only in their country.
Types of exchange rate risk for startups
These three types of risk show how currency fluctuations can affect businesses in different ways and timeframes, even if they primarily do business in their own country.
Transaction exposure – short to medium-term risk
This is about how currency exchange rate changes affect a startup's short to medium-term financial obligations, like bills or payments in foreign currency. For example, if a business in the US buys materials from a European supplier and the euro strengthens, it might cost more dollars to pay for those materials.
Translation exposure – medium to long-term risk
This happens when currency fluctuations affect a business's long-term financial statements, especially if it has foreign branches or subsidiaries. For example, a company might see changes in the value of its foreign assets or debts due to shifts in exchange rates. This can impact its financial health over time.
Economic exposure – long-term risk
Economic exposure is less known but essential. It's about how unexpected currency changes can affect a business's long-term profits and overall value, even if it mainly operates in its home country. For example, imagine a local US furniture maker. If the dollar gets stronger, imported furniture from Asia and Europe becomes cheaper, making it harder for the local company to compete, even though it doesn't sell overseas.
The impact of foreign exchange rates on companies
Here is a quick look at how different exchange rates impact businesses that engage in international trade directly.
Exchange rate effects on imports
If your company depends substantially on imported products, a decline in the value of your currency will result in higher costs for those products.
When prices rise, consumers typically respond by reducing their spending. You risk having less success selling your products if their price increases.
However, if your currency strengthens and rises in value, you may spend less on imported products and services. Keeping your selling price steady while stocking up on additional items equals more money in your pocket.
Exchange rate influence on exports
Any shift in the currency's value might affect how much customers in your target market are willing to spend on your products or services.
Customers in that nation will have to pay more local currency for their goods or services if the pound strengthens versus their currency. Because of the higher price, fewer customers may buy your items.
However, if the pound declines in value relative to the local currency, your product or service will become more affordable to local consumers, increasing sales.
Minimise exposure to exchange rate risks
Take advantage of forward contracts
Hedge against inflation with the help of forward contracts to lock in a fixed exchange rate at a future date.
If your firm in the United Kingdom must be paid in American dollars in three months, your customer can enter into a forward contract at a predetermined exchange rate. There will be no need to worry about the value of the pound dropping before the payment is due.
Reduce the number of currencies you deal in
Reducing the number of currencies your organisation employs is a simple and efficient strategy to control swings in exchange rates and avert substantial financial losses. It is easier to keep up with currency swings if there are fewer currencies to keep track of.
Diversify currency holdings
This involves maintaining accounts and reserves in multiple currencies. When you need to pay foreign suppliers or deal with foreign transactions, you can use the money you already hold, minimising the need for immediate conversion. You can also wait for favourable exchange rates before making currency conversions, potentially saving on conversion costs.
Maintain flexible pricing
Consider implementing dynamic pricing strategies that adjust product or service prices based on real-time exchange rate fluctuations. This can help you remain competitive and protect your profit margins. Use discounts or promotions strategically during good exchange rate movements to incentivise purchases and offset increased customer costs. Communicate pricing changes clearly to your customers to maintain trust and transparency. Explain the reasons for price adjustments, such as currency fluctuations, to build customer understanding. You can also invoice your international customers in your currency.
Monitor exchange rates
Use financial news sources and currency exchange rate platforms such as TradingView to track real-time currency movements. Automated alerts can notify you of significant rate changes. Stay informed about economic indicators, such as interest rate changes, inflation rates, and geopolitical events, as they can influence exchange rates.
Expanding your customer base to include various geographic regions can help reduce your reliance on a single market. Target multiple international markets to spread your risk. Conduct thorough market research to identify areas with growth potential and assess their economic stability.
Ultimately, the influence of currency exchange rates on enterprises can be both good and bad. You must be proactive and prepared to ensure your business runs well. You should have a vast network of international suppliers to provide access to quality products at competitive prices if your company's primary focus is on importing items – regardless of the local currency exchange rate.