As we all know, exchange rates fluctuate all the time.1 The pound can rise in value compared to the dollar one day, and fall the next. These constant shifts create what’s known as foreign currency risk: the potential for changes in exchange rates to impact the value of your money when moving funds across borders.
Lots of factors influence currency markets, from central bank interest rate decisions to economic growth. But regardless of the reasons behind foreign exchange (FX) fluctuations, the impact on your own revenues can be significant.2
Quite simply, foreign exchange movements are a business risk:
- If you export goods or services and invoice international customers, FX rates can reduce the value of the payments you receive.
- If you import components or pay overseas contractors, FX fluctuations can mean they cost you more than you expect.
- In short, FX movements can impact revenue, margin and profitability.
So the constant ebb and flow of exchange rates can cost you money, but it doesn’t have to. In this article, we’ll help you identify and measure FX risk in your business. In the next piece, we’ll show how FX movements can be used to your advantage.
What is foreign currency risk and why does it matter?
Put simply, foreign currency risk or foreign exchange risk is the threat of financial loss due to fluctuating exchange rates. When currencies strengthen or weaken relative to each other, businesses with international sales, operations or suppliers can see costs and revenues rise or fall.3
This is particularly true when there is volatility in foreign exchange markets. Geopolitical tensions, political upheaval and economic uncertainty can all cause exchange rates to fluctuate more markedly than they otherwise would. Tariffs also cause uncertainty in money markets.4
There are several reasons for this, but at their core they all involve investors chasing the best or most stable returns. Central banks use higher interest rates to combat inflation, for example, and higher rates tend to increase the value of a country’s currency compared to competitor currencies, because they attract foreign investment. Lower interest rates can weaken a country’s currency.5
For business, the important point is that the more FX rates fluctuate, the higher your currency risk. Large businesses hedge against this risk as a matter of course, but most SMEs don’t. That puts them at significant competitive disadvantage.
Three types of foreign currency risk
Businesses face three main types of currency risk.6
Transaction risk: the main threat for SMEs
This is the risk that occurs from foreign currency transactions, and is the risk SMEs most commonly face. It’s caused by fluctuations in the exchange rate, added to the delay that can occur between the initial transaction and the settlement of the payment.
Let’s say you order goods from a German supplier in euros, placing the order four months in advance. If the euro strengthens against the pound between the order and settlement dates, you could end up having to pay more in pounds than you originally expected. If it’s a large order, that could cost you thousands or even tens of thousands of pounds.
Translation risk: the cost of converting assets
This is a less common risk for SMEs, but it’s certainly not unknown. With translation risk, overseas assets and revenues can gain or lose value when converted into the organisation’s home currency for reporting purposes.
For example, when your overseas sales office sends its financial statements in euros, the value of those revenues on your consolidated balance sheet – calculated in pounds – could be impacted by the exchange rate between the two currencies, potentially affecting your financial position.
Economic risk: undermining long-term competitiveness
Taken together, currency trends can impact your profitability in the long term, and your ability to compete. FX volatility makes financial planning and forecasting more difficult. It can even make transactions with foreign customers potentially unviable. By contrast, competitors who know their FX risk and hedge against it face far fewer obstacles to overseas operations and gain competitive advantage as a result.
How to identify currency exposure
What can SMEs do about this risk, and the threat it poses to revenues, profitability and margins? The first step is to identify your exposure to exchange rate movements.
Do you:
- Invoice in foreign currency?
- Pay overseas suppliers or staff?
- Have foreign currency in your profit and loss (P&L) statement or cash flow?
- Have exposure to contracts that are dependent on exchange rates?
If you can tick yes to any of these then you are exposed to FX risk. If you don’t know for certain, pull up a recent P&L or cash flow document and highlight any FX-related items. Also consider your short- and medium-term plans. If you have ambitions to sell overseas or engage foreign suppliers in future then it’s worth thinking about FX risk now to avoid any unexpected costs.
If you’re not sure what your current or future FX risk might be, Lumon can help. We can walk you through the process of identifying FX-related items, making sure your exposure is fully captured. That’s the first step towards reducing risk and starting to use FX rates to your advantage.
How to measure the size of your FX exposure
After identifying your exposure, it’s a good idea to quantify it. It doesn’t have to be 100% accurate, but working out roughly how much your exposure might cost over time can be a good way of prompting action in the business.
Use the FX-related items identified on P&L or cash flow statements to work out the potential monthly or quarterly cost of transactions that contain an FX element. You can estimate future exposure using the volume of relevant invoices you typically send in the chosen time frame, and the average size of past transactions.
Again, you don’t have to do this alone. Lumon can help you put a monetary figure on your potential FX exposure.
Don’t worry if you can’t capture everything, or that a certain amount of educated guesswork is involved. At this stage, even a partial awareness of your risk is a big step forward.
How to mitigate against foreign currency risk
If currency risk sounds worrying, it needn’t be. It’s quite possible to plan for FX volatility and protect yourself against it.
Foreign exchange risk happens when there’s a delay between agreeing a payment and actually making it, which can often be the case with international transfers. Because exchange rates can change during that time, the amount you end up paying (or receiving) could be more or less than expected. That movement in the rate can lead to a potential loss for one of the parties involved.
Once you know your exposure to currency risk, a series of potential solutions and mitigations present themselves. These include forward contracts (a non-standard agreement to buy or sell at a specific exchange rate in future), market orders (ensuring a quick settlement of any transaction) and sophisticated budgeting tools.
Again, while some of these solutions might sound complex, Lumon can support you as you take steps to protect yourself from currency risk. You don’t have to do any of it alone.
In our next article, we’ll discuss how these tools work in practice. Click here to read “Components of an effective hedging strategy”.
Sources used:
1 HoC library – Sterling exchange rates
2 Science Direct – Exchange rate fluctuations and impact on SMEs
3 Bank of England – Who sets exchange rates
4 IMF – Global economy enters a new era
5 Nasdaq – Interest rates and exchange rates
6 Queen Mary University – Transaction and translation risk
Sources last checked on date: 05/06/2025
This publication is provided for general information purposes and does not constitute legal, tax or other professional advice from Lumon or its subsidiaries, and it is not intended as a substitute for obtaining advice from the relevant professional services. We make no representations, warranties or guarantees, whether expressed or implied, that the content in the publication is accurate, complete or up to date.
