Margin risk is an accounting term that refers to the probability that economic developments might have a negative impact on the profit margins of a company’s expected cash flow.
The concept of margin risk is very well known among international businesses whose sales and/or purchases are denominated in foreign currencies, as this sort of risk may lead to substantial FX gains and losses.
The sales cycle of an exporter offers a good example of how margin risk works:
Let’s imagine a European company selling their products in US dollars to another company located in the US. From the moment they sign a sales contract, the seller’s margins will be exposed to the fluctuation of the EUR/USD.
The buyer commits to pay US dollars on a future date, for instance in three months. The exporter, however, will have to register the value of that expected cash flow in euros and update it in every reporting period using the prevailing spot rate. During those three months, the fluctuations in the EUR/USD will trigger FX gains and losses and variations of the profit margins.
If the exporter has a margin of, say 10%, the variations of the EUR/USD exchange rate will have a tenfold impact on the company’s margin. If, for instance, the dollar depreciates 2% against the euro in the meantime, on the payment date that 2% depreciation would wash out 20% of the company’s profits.
To avoid the impact of those FX gains and losses, international businesses acquire forward contracts to lock in the exchange rate from the moment of the sale or purchase agreement. In the case of companies with significant sales volumes, there are sophisticated FX software solutions that allow them to microhedge each transaction as it occurs.