What is conversion risk?

Selling in a global economy means finding ways to collect international payments more effectively. When you’re accepting payments in a foreign currency, there’s some element of risk involved. This is because currencies continually fluctuate. What happens if the value of currency plummets before you’re able to settle the transaction? This is a factor known as conversion risk – here’s how it works.

What is the conversion risk definition?

Currency exchange rates aren’t fixed, with values fluctuating due to everything from inflation to civil unrest. Also known as transfer risk, conversion risk describes the potential that you won’t be able to convert one currency into another at the intended rate. This could be due to sudden changes in value, new restrictions, or market conditions. If you’ve already accepted a customer’s payment in this foreign currency and are unable to convert it into your own currency, you would then lose the money. 

The conversion risk definition also applies to debt repayments when a borrower can’t convert local currency into foreign exchange. This means they’re unable to make their debt repayments.

How does transfer risk work?

For transactions involving long-term stable currencies like USD, EUR, or JPY, currency conversions are usually straightforward. Yet as your business expands its reach into new markets, it’s important to be aware of increased conversion or transfer risk. When you conduct business in a different country, your transaction is subject to that government’s regulations. This includes factors like banking regulations, commerce restrictions, different port and shipping laws, and currency conversion restrictions – all of which impact the total transfer risk.

What is an example of transfer risk?

We’ve mentioned a few different reasons for transfer risk above, but what does this look like in real life? One example would be if you’ve deposited funds in a foreign bank account. Due to the country’s banking regulations, you’re unable to transfer this deposit to the United States for six months while the funds are held. Imagine that during this time the value of the currency decreases, which means your business loses money on the transaction with little recourse.

As a second example of conversion or transfer risk, imagine that a US-based manufacturer has signed a contract to provide its products to a company based in the EU. At the time of sale, the contract deal was for EUR 15,000. However, the delivery date is six months after the contract date, during which time the Euro loses value in comparison to the US dollar. While the manufacturer is still paid its Euro 15,000, this is now worth less when converted to USD. 

How to reduce conversion risk

While there’s no fool-proof way to eliminate conversion risk, you can reduce it using several methods. The first is to only send invoices and contracts in your home currency, in this case the United States dollar. That ensures your revenue and expenses remain in the same USD and transfers the element of risk to your overseas business partners. The downside is that they may increase fees to compensate for this risk accordingly.

GoCardless can reduce conversion risk when you collect international payments. Businesses can collect payments using bank debit in over 30 countries, integrating it with additional payment methods to best suit customer preferences. By offering the local bank debit option in supported countries, you’ll receive payments at the real exchange rate rather than dealing with fluctuations over time. In other words, customers pay in their local currency, and you receive it in dollars. No foreign bank account is required, which means your funds won’t be held ransom to regulatory changes. This offers a way to reduce some of the barriers and costs associated with overseas commerce.

We can help

GoCardless is a global payments solution that helps you automate payment collection, cutting down on the amount of financial admin your team needs to deal with. Find out how GoCardless can help you with one-off or recurring payments.