Foreign exchange (FX) risk is the possibility that movements in exchange rates change the sterling value of your costs, revenues or assets. For UK importers and exporters, FX risk can directly affect cash flow, gross margin and competitiveness. This long‑form guide explains what FX risk is, the main types you’ll encounter, how to measure exposure, and the practical hedging choices finance teams can use—without hype.
What is foreign exchange risk?
FX risk (also called exchange‑rate or currency risk) arises whenever the cash flows, assets or liabilities of your business are denominated in a currency other than your reporting or functional currency (for UK groups, typically GBP). Because rates move continually, the sterling value of those items can rise or fall between transaction and settlement—or between reporting dates for accounting translation.
At a high level, exchange rates are set in global markets by supply and demand and can be influenced by interest‑rate expectations, risk appetite and trade flows. That’s why the same move in GBP can make imports cheaper for some businesses and exports less competitive for others.
The three core types of FX risk
1) Transaction risk (cash‑flow risk)
This is the risk that the sterling value of a known foreign‑currency payable or receivable changes before you settle it. Example: a GBP buyer with a USD invoice due in 60 days faces the risk that GBP/USD falls, making the purchase more expensive in GBP terms. Transaction risk is usually the first priority because it hits cash flow directly.
2) Translation risk (accounting risk)
When you consolidate a foreign subsidiary’s results or remeasure foreign‑currency balances for reporting, exchange‑rate moves change reported GBP values. This can affect equity and ratios even if local‑currency cash generation is steady. Translation is governed by accounting standards that prescribe which rates to use and how to present exchange differences.
3) Economic risk (operating/competitive risk)
Economic risk is the long‑run effect of currency moves on your future cash flows and market position. A stronger GBP can pressure UK manufacturers by making imports cheaper and UK exports less competitive; a weaker GBP does the reverse. Economic exposure is broader and harder to quantify, so it’s often managed with operational choices (pricing, sourcing, market mix) alongside selective financial hedging.
Other FX‑related risks to be aware of
- Settlement risk (counterparty/Herstatt): the risk one party delivers currency but the other fails to deliver. Industry infrastructure such as CLS reduces this risk, but treasuries should still control counterparties and cut‑off times.
- Transfer/inconvertibility risk: capital controls or inconvertible currencies can delay or prevent conversion/transfer—even if commercial terms are sound.
- Contingent/bidding risk: exposure that arises if you win a tender or sign a contract; risk becomes transactional once obligations are firm.
How to measure your exposure
Start with a simple exposure map. For each line item, capture: currency pair and direction, amount, timing (invoice/shipment/settlement), certainty (committed vs forecast), and the business driver (e.g., PCB batch run, seasonal produce, LME‑linked shipment). Group by month/quarter so you can see where coverage is needed and how sensitive margin is to moves in GBP/USD or EUR/GBP.
Two practical metrics help with governance:
- Hedge coverage vs plan: percent of committed purchases/sales that are already covered within policy bands.
- Variance to budget rate: difference between realised rate and your internal planning rate for the period.
Hedging approaches: getting the mix right
The right mix gives certainty where you need it and flexibility where you can afford it. Common building blocks include:
Natural hedging
Match inflows and outflows in the same currency (e.g., hold USD revenue to pay USD suppliers). Also consider pricing/invoicing currency, and aligning borrowing currency with asset or revenue currency. Natural hedging reduces reliance on derivatives.
Forwards (including window/open‑dated and dynamic variants)
Forwards secure a rate for a future date, supporting cash‑flow predictability for known purchases or sales. Window (open‑dated) or more flexible “dynamic” forwards allow delivery in a time window or with features that add flexibility—typically at the cost of a less favourable rate or an added premium.
Layered or rolling hedging programmes
Many teams spread cover across maturities (e.g., 3–6–9 months) to smooth timing risk and average the achieved rate over time. Rolling programmes replace maturing hedges with new ones, keeping coverage within policy bands.
Market orders (limit & stop‑loss)
Limit orders target an improved rate; stop‑loss orders set a floor to cap downside if volatility spikes. Pre‑place orders around policy levels so you don’t have to watch the market continuously.
Options (use selectively)
Options can protect against adverse moves while allowing upside, but premiums add cost. They may suit higher‑margin or high‑uncertainty scenarios; they are often less suitable for routine SME purchases.
Building a policy that actually gets used
A short written policy reduces decision friction and aids auditability. Keep it practical:
- Objective: protect gross margin and cash‑flow predictability.
- Budget rate & triggers: set internal planning rates and pre‑agree actions if breached.
- Hedge‑ratio bands: e.g., 60–80% on committed purchases; lighter coverage for forecasts.
- Permitted instruments: natural hedging, forwards (including window/dynamic), market orders; evaluate options case‑by‑case.
- Approvals & records: sign‑off thresholds, trade logs, and a short monthly coverage/variance review.
Sector specific notes
Electronics & industrials
Thin margins magnify small rate changes. Pre‑place market orders around production/shipping windows to avoid paying up during intraday swings.
Food & agriculture
Seasonality and perishability increase timing risk. If sector data releases pause, lean on exchange prices and broker updates; tighten approvals for larger purchases.
Metals & raw materials
LME‑linked pricing and USD/CNY exposures benefit from layered forwards. Align tenors to shipment/payment schedules to avoid mismatches.
Checklist
- List all FX exposures by currency and month (committed vs forecast).
- Agree budget rates and hedge‑ratio bands.
- Choose instruments: natural hedging; forwards (incl. window/dynamic); limit/stop‑loss orders; options if justified.
- Execute against policy; document trades; monitor margin headroom on forwards.
- Hold a short monthly review; adjust levels and instruments accordingly.
