Do you know your FX risk and hedging requirements?

Operating a business across borders comes with the challenge of managing foreign exchange (FX) risk.

In today’s volatile market, ignoring FX risks isn’t just a missed opportunity; it’s a financial threat that could wipe out quarterly profits in moments. Our North America FX report found that 4 in 5 businesses have experienced losses due to unhedged FX risk so far in 2025.

For many globally active firms, FX risk management is no longer a back-office concern—it’s a strategic priority firmly back on the boardroom agenda.

In this blog, we’ll break down the essentials of FX risk, explore how it impacts businesses, and outline common hedging strategies for effectively managing it:

• What is FX risk?
• Identifying and assessing your FX risk exposure
• Identifying your FX hedging requirements
• Tools for managing FX risk effectively

 

What is FX risk?

Foreign exchange (FX) risk, or FX risk, refers to the financial exposure businesses face when operating across multiple currencies.

FX risk arises from the potential for losses due to unfavourable changes in exchange rates, often driven by market volatility. This volatility can stem from factors such as interest rate fluctuations, shifts in market sentiment, economic changes, and geopolitical events, all of which can significantly impact a company’s earnings before interest, taxes, depreciation, and amortization (EBITDA).

 

Identifying and assessing your FX risk

Foreign exchange exposure looks different for every business. Some juggle frequent, smaller transactions across various currencies, while others handle large, occasional cross-border payments. Understanding your unique FX risk profile is the first step to developing an effective FX risk management strategy.

When evaluating your business’s FX exposure, consider the following key areas:

Transaction exposure

Transaction exposure can arise when a business enters into to a cross-border payment or receivable that has not yet been settled. The risk stems from exchange rate fluctuations occurring between the date the transaction is agreed and the date when the resulting FX requirement is executed. These currency movements can lead to unexpected gains or losses, directly affecting the value of revenue or costs in the business’s reporting currency.

 

Translation exposure

Translation exposure, also known as accounting exposure, can arise when a multinational company consolidates the financial statements of foreign subsidiaries into its functional or reporting currency.

This risk materialises due to exchange rate movements between the local currency of the subsidiary and the reporting currency of the parent entity. As exchange rates fluctuate, the translated values of assets, liabilities, revenues, and expenses can vary significantly, resulting in unrealised gains or losses. These accounting adjustments do not reflect actual changes in asset values, but they can still impact reported earnings and equity positions.

 

Economic exposure

Economic exposure, also known as operating exposure, refers to the broader and longer-term impact of exchange rate fluctuations on a firm's market value, cash flows, and competitive positioning. Unlike transaction or translation exposure, economic exposure arises from macroeconomic shifts, geopolitical events, or changes in market sentiment that influence currency movements over time.

Exchange rate volatility can affect both the cost structure and revenue potential of a business. For example, by making exports less price-competitive or increasing the cost of imported goods. A strong domestic currency may reduce demand for a company’s goods abroad, eroding market share and future cash flows.

 

Identifying your FX hedging requirements

Hedging is the practice of using financial strategies and instruments to minimise or offset FX risks. Different strategies suit different business needs, and tailoring your approach is essential. Below are some common hedging strategies:

• FX Forward
• FX Option
• FX Swap
• Natural hedging

 

FX Forward

An FX forward, also known as a currency forward, is an over-the-counter (OTC) derivative contract where two parties agree to exchange specific amounts of two currencies at a predetermined rate on a specified future date.

The exchange rate is agreed at the outset of the contract, making FX forwards a widely used tool for hedging against adverse currency movements and managing FX risk. This form of hedging is fully flexible in terms of notional amounts and maturities, although one-month or three-month tenors are most common, as they tend to offer better liquidity and lower transaction costs.

 

FX forward contract example:

A UK-based business (reporting in GBP) secures an export deal with a US client worth $500,000, with payment due in three months. Concerned that the US dollar may weaken against the pound, reducing the value of the future payment, the firm enters into a forward contract to lock in the current exchange rate.

Forward exchange rate: The UK business secures a rate of 0.68 USD/GBP

Transaction amount: $500,000 × 0.68 = £340,000

Settlement: After 3 months, regardless of the prevailing spot rate, the UK business receives £340,000 (minus any transaction or other related costs).

By using the forward contract, the company eliminates the uncertainty of future currency movements, protecting its profit margin and improving cash flow forecasting.

 

FX Options

FX options, or forex options, are derivatives that can be traded over-the-counter (OTC) or, less commonly, on exchanges. These contracts grant the holder the right, but not the obligation, to exchange a set amount of one currency for another at a predetermined exchange rate (strike price) by a specific expiration date, depending on the type of option.

FX options are growing in popularity, with 86% of corporates in North America and 64% in the UK reporting more frequent usage. A major difference between option contracts and forwards is the flexibility to exit the trade if a more favourable exchange rate becomes available in the open market. This allows businesses to mitigate downside risk while maintaining some upside potential, however this does mean option contracts often carry high premiums which isn’t reimbursed if the trade is not settled.

 

FX option contract example:

A UK-based corporate is due to receive $10 million from a US customer in one year as part of a long-term supply agreement. Concerned that the USD may weaken against the GBP over the next 12 months, the company decides to enter into an FX options contract to hedge its FX risk. There are three possible outcomes of this trade.

 

Outcome one: Favourable strike price

At expiry, the spot USD/GBP rate is 0.76, making the strike rate of 0.78 more favourable. The firm exercises the FX option to lock in the higher conversion rate:

• Strike rate conversion: $10M × 0.78 = £7.8M

• Spot rate conversion: $10M × 0.76 = £7.6M

Intrinsic value of the option =  (strike rate – spot rate) * notional principal = (0.78 – 0.76) × $10M = £200,000

Outcome: The business avoids a £200,000 shortfall by exercising the option, securing a stronger cash inflow in GBP. The premium paid for the option is not recovered, but the downside is effectively hedged.

 

Outcome two: Market rate is more favourable than strike rate

At expiry, the USD/GBP spot rate has moved to 0.79, making it more advantageous than the strike rate of 0.78. The company allows the option to expire and converts the funds at the prevailing market rate using a spot contract.

• Option value (if exercised): $10M * 0.78 = £7.8M

• Spot value: $10M * 0.79 = £7.9M

Outcome: The company benefits from the stronger market rate, receiving an additional £100,000 compared to the strike rate. However, the option premium is not recovered.

 

Outcome 3: Market rate equals the strike rate

On the settlement date, the spot rate is exactly 0.78, matching the strike rate.

• Option value: $10M × 0.78 = £7.8M

• Spot value: $10M × 0.78 = £7.8M

• Intrinsic value: £0

Outcome: The option has no intrinsic value, and the company is indifferent between exercising the option or using the spot market. The only cost incurred is the premium that was paid to purchase the option.

 

FX Swap

An FX swap is an over-the-counter (OTC) derivative in which two parties exchange notional amounts in different currencies at the prevailing spot rate, with a simultaneous agreement to reverse the exchange at a pre-agreed forward rate on a specified future date. This structure is often used for short- to medium-term hedging or liquidity management.

This hedging strategy involves two key transactions, typically exchanging notional principals between currencies:

Leg one – Spot exchange: The parties exchange a specified notional amount in one currency for an equivalent amount in another at the current spot rate.

Leg two – Forward exchange: On the agreed future date, the two parties reverse the initial exchange using the forward rate set at the start of the contract. This rate typically differs from the original spot rate, reflecting anticipated interest rate differentials and expected currency movements. The notional amounts are exchanged back into their original currencies.

 

FX Swap example:

Two multinational corporations are looking to meet short-term liquidity requirements in foreign currencies—without taking on unwanted FX risk.

• Company A (USD-based): A US-headquartered electronics firm preparing to make supplier payments in Europe. It needs €11 million for the next quarter.

• Company B (EUR-based): An Italian automotive company expanding into the US market. It requires $12 million to cover initial operational expenses.

Rather than each converting funds through the FX spot market and exposing themselves to potential exchange rate volatility, they agree to a 3-month FX swap to meet their needs while locking in the future rate.

 

Step		Company A (USD side)		Company B (EUR side)
Initial Spot Transaction		Pays $12 million		Receives €11 million (at 1.090909 USD/EUR)
		Receives €11 million		Pays €11 million
				Receives $12 million
Final Forward Transaction		Returns €11 million		Returns $12.21 million (at 1.11 USD/EUR)
		Pays $12.21 million		Receives €11 million

 

Natural Hedging

While hedging instruments like forward contracts and FX swaps are commonly used to manage currency risk, many corporates also use natural hedging as a strategic first line of defence. Natural hedging involves structuring operations and cash flows in such a way that foreign currency inflows and outflows offset each other, reducing net FX exposure.

 

Natural hedging example:

A UK-based manufacturing business exports industrial equipment to clients across the EU, generating €5 million in annual revenue. Previously, the firm converted these euros into GBP upon receipt, exposing it to currency risk.

To reduce this exposure without using derivatives, the company adopted a natural hedging strategy:

• Procurement in euros: Instead of sourcing all components from UK suppliers, the company began purchasing parts from European vendors in euros.
• Retaining earnings: The business chose to reinvest a portion of its euro profits into EU marketing, rather than converting them immediately into GBP.

 

Tools for identifying and managing FX risk effectively

Effective FX risk management begins with visibility. Businesses should understand where, how, and to what extent they’re exposed to currency movements before choosing the right hedging strategy. MillTech supports this process by equipping corporates with data-driven insights, through our next-generation risk advisory and calculation services.

1. Map your exposure with Co-Pilot

Gain a clear picture of your currency risk with Co-Pilot, enabling you to make informed decisions:

• Convert your raw exposure data into meaningful, actionable insights.
• Model and compare hedging strategies across instruments and maturities.
• Simulate alternative FX and liquidity scenarios with real-time analytics.
• Track the cost/carry across different currencies, instrument and time horizons.
• Assess the impact on key metrics such as cash flow, internal rate of return (IRR), and broader financial performance.

 

2. Execute an informed FX hedging strategy

Once your exposures are identified, MillTech’s FX management solution enables you to act decisively with institutional-grade execution tools:

• Access transparent, multi-bank preferential pricing from up to 15 tier-one liquidity partners.
• Lock in competitive rates with full visibility on costs, spreads, and market benchmarks with quarterly transaction cost analysis reports.
• Streamline trade execution directly through the platform with automated settlement.
• Maintain a complete audit trail for regulatory and trade reporting.

 

Want to learn more about how our FX solutions can support your firms FX risk management strategy? Get in touch with the team here.

 

Please refer to our Research Disclosure Page for more information on the data referred to in the above.