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.
Foreign exchange rate fluctuations have an impact on business organisations that operate in the global economy.Their managers are exposed to them as well as their bottom lines.
Corporate foreign exchange risk management is a set of rules that help protect the value of cash flows and currency assets or liabilities from adverse fluctuations of the exchange rate.
In the real world, 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 risk exposure and isolate their bottom line from FX market volatility. By entering a financial contract to hedge currency risk, the business manager is effectively protecting the exchange rate against a specified amount of currency for a predetermined period of time.
One of the benefits is that the FX mitigation strategy will provide certainty and the ability to better plan financials. This means that a fixed exchange rate for a certain period of time will allow the finance department to plan and prepare for that time in advance. This ultimately gives a control over business flows and potentially increases 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 great confidence that there won’t be any surprises in currency positions.
And lastly, exchange rate protection is going to fix the value of the short- and mid-term assets of the company. This creates 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 the cost of hedging or potentially missing the appreciation of the hedged currency.
In a similar vein, there are a few questions to be considered before entering into any hedging transactions:
What does your company want to achieve with one or another hedging transaction? It is important to have a clear goal that will help determine the right hedging tool and strategy.
What is your company 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, adjusting the price for customers can have a direct impact on profitability. As well as incurring losses from currency depreciation. The balance has to be prudently measured.
How feasible is it to forecast a company’s currency needs accurately? Usually, historical data should help forecast 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 the FX market?
And lastly, will your business have funds to cover the maturing contract that is in the red? Hedging means locking in the currency value regardless of the movements of the FX market. And it is important to understand that currencies not only lose value but can also appreciate, which means funds will be 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 that 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 of the most common instruments used to implement those strategies:
Forward contract. A forward contract is a type of transaction where two parties agree to exchange one currency for another at a pre-determined exchange rate and maturity date.
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 currencies at the current market rate (on the spot).
FX vanilla options FX options give the right but not the obligation to exchange one currency for 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 are 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 the mentioned products. Before that, it is important to understand that hedging solutions should be consistent with the overall business strategy and should not be used as a form of speculation.
Layered hedge. A layered hedge is a series of separate open forward contracts with different expiration dates to cover certain parts of a company’s FX risk over a certain period of time. A business manager might open new contracts every week or month for specific expiration dates in line with the overall financial forecasts, thus keeping the layered hedge. This strategy enables businesses to monitor and adjust to changes in FX risk exposure.
Market orders. A "market order is an agreement to transact in a particular currency at the current moment. It can also be used to hedge by opening a position opposite the currency that is being hedged. If an EU-based company is expecting $1 million of cashflow in USD in two months, the market order is being executed by entering into a spot transaction to "buy" the EUR/USD’ pair. Such a trade will produce profits in cases of USD depreciation against EUR and losses in cases of USD appreciation against EUR.
Long Put. This is an options strategy to protect businesses from a potential downside in a particular currency by having the right but not the obligation to exchange it at a predetermined exchange rate.
There are more hedging strategies, but it comes 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 to our clients licensed payment and FX specialists that have longstanding industry experience and top-tier banking partnerships to provide quality service. Please reach out to us to get a list of the best-in-class FX and payments platforms.
The Epico Finance team is working with companies of all sizes and industries. We not only help by providing the tools that you need for your unique FX risk management strategy but also have a dedicated relationship manager that will help you assess all available options.
All in all, organisations 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.