What Is Corporate Foreign Exchange Exposure And Risk Management?
If you’ve ever been wondering how foreign exchange risk management can benefit your business, then please keep reading on.
Business organizations that are active in global economy are more or less impacted by foreign exchange rates fluctuations. Their managers are exposed to them as well as bottom lines.
Corporate foreign exchange risk management is a set of rules that help to protect the value of cash flows and currency assets or liabilities from adverse fluctuations of the exchange risk.
In the real life, such risk management would be implemented using various hedging strategies and instruments that we are going to talk about now.
What Are The Benefits Of Foreign Exchange Risk Management?
As discussed already, hedges are used by businesses to manage their currency risks exposure and isolate bottom line from FX market volatility. By entering a financial contract to hedge currency risk business manager is effectively protecting the exchange rate against specified amount of currency for a predetermined period of time.
One of the benefits is that FX mitigation strategy will provide a certainty and ability to plan financials better. This means that a fixed exchange rate for a certain period of time will allow finance department to plan and prepare for that time in advance. This ultimately gives a control in business flows and potentially profitability.
On top of that, another benefit of currency hedging is the protection from adverse FX market movements and improved company management. So the directors can accurately forecast and implement corporate strategies with a great confidence that there won’t be any surprises in currency positions.
And lastly, exchange rate protection is going to fix the value of short and mid-term assets of the company. This creates a certainty over the balance sheet and business transactions that encompass those hedged assets.
What Should You Consider Before Hedging Your FX Risks?
When implementing a hedging strategy it is important to weigh the benefits versus cost of hedging or potentially missing the appreciation of the hedged currency.
In the similar vein, there are a few questions to be considered before entering into any hedging transactions:
- What your company wants to achieve with one or another hedging transaction? It is important to have a clear goal that will help to determine the right hedging tool and strategy.
- What your company is aiming to achieve with a selected hedging strategy? This question should help to determine the extent of the hedge.
- How can you cover the costs of the hedge? It is important to understand that the hedge has a price. And that should be calculated into the profit margin and properly forecasted.
Nevertheless, re-adjusting the price for customers can have a direct impact to the profitability. As well as incurring losses from currency depreciation. The balance has to be prudently measured.
- How feasible it is to forecast company’s currency needs accurately? Usually, the historical data should help to forecasts the currency needs of your business. This is needed in order to accurately size the hedging contracts as, for example, forward contracts require you to commit to a certain amount for the set period.
- Is there a revenue stream that supports currency hedging requirements? Is not only the cost to pay for a hedging contract but also the margin requirement to cover.
A provider is going to ask for an upfront deposit to secure the currency contract. Even further, is your business able to pay an extra deposit in case there is a significant move in FX market?
And lastly, will your business have funds to cover the maturing contract that is in the red? Hedging means locking the currency value regardless the moves of FX market. And it is important to understand that currencies not only lose value but also can appreciate, which means there will be funds needed to settle the contract with your provider.
What Are The Foreign Exchange Risk Management Strategies?
Let’s now move onto the types of hedging transactions. There are a few your business can use and it is important to understand the nature of each one of them at least in general terms.
But before that, a short review on most common instruments used to implement those strategies:
Forward contract. Forward contract is type of transaction where two parties agree to exchange one currency for another at a pre-determined exchange rate and maturity date. We have a whole different article about forward uses here.
Spot transaction. A spot transaction is a foreign exchange transaction with a T+2 settlement ( settled in two days). Basically, two parties agree to exchange currency at current market rate (on the spot).
FX vanilla options. FX option gives right but not the obligation to exchange one currency with another at a pre-agreed exchange rate on a specific date in the future. FX options are usually used to hedge uncertain business cash-flows. The premium for the option is paid upfront and there is no extra costs or losses to cover besides the loss of the premium.
Moreover, we are going to review several hedging strategies that can be implemented with mentioned products. Before that, it is important to understand that hedging solutions should be consistent to the overall business strategy and it should not be used as a form of speculation.
Layered hedge. A layered hedge is a separate open forward contracts with different expiration dates to cover certain parts of company’s FX risk over a certain period of time.
A company might open new contracts every week or month for a specific expiration dates in line with the overall financial forecasts thus keeping the layered hedge. This strategy enables business to monitor and adjust to the changes in FX risk exposure.
Market orders. Market order is an agreement to transact in a particular currency at a current moment. It can also be used to hedge by opening a position opposite to the currency that is being hedged.
If EU based company is expecting 1 million of cashflow in USD in two months, the market order is being executed by entering into spot transaction ‘BUY EUR/USD’ pair. Such trade will make profit in case of USD depreciation of EUR and lose money in case of USD appreciation against EUR.
Long Put. This is an options strategy to protect business from a potential downside in a particular currency by having right but not obligation to exchange it at a predetermined exchange rate.
There are more hedging strategies but it goes down to a specific business need and cash flows. In order to have an appropriate hedging strategy you should consult with a currency specialist or your FX and payments service provider.
What Is The Best Foreign Exchange Risk Management Provider?
We recommend licensed payments and FX specialist – IFX Payments. IFX is a bespoke provider of foreign exchange, risk management and international payments services.
IFX Payments are working with companies of all sizes and industries. They are not only able to provide tools you need for your unique FX risk management strategy but also a dedicated relationship manager that will help you to asses all available options.
In addition, their unique payments platform is able to perform payments in 100+ currencies to 120+ countries. The bank account provided by IFX will allow incoming payments in 39 currencies too.
All in all, organizations that are active in multiple markets will have exposure to foreign exchange risks and should be ready to manage that risk appropriately. There are available tools and FX risk mitigation strategies that any business can implement. Moreover, such providers like IFX Payments will be able to provide a dedicated relationship manager and access to FX trading desk to help you manage your foreign exchange risks.