A good foreign exchange (FX) risk management is important for any organisation that deals in international trade. The values of major currencies constantly fluctuate, which generates uncertainty and can have long-lasting consequences for those who do not plan appropriately.
It is impossible to predict volatility. Therefore finance managers must create a strategy that aligns with desired objectives, risk tolerances, and budgets.
In this article, we’ll provide an overview of FX risk management, explain why you need a comprehensive FX policy in place, and detail how you can ensure the sustainability of your business in uncertain times.
Why do you need a foreign exchange risk management policy?
The absence of a foreign exchange management policy may leave your organisation unable to compensate for, or control adverse effects caused by currency movements. This can result in increased operating costs, increased procurement costs and lower profit margins. A policy which describes your business’s attitude towards currency risk and outlines appropriate responses to FX risk can help mitigate negative outcomes.
Adopting a clearly stated FX policy can also:
- Minimise any misunderstanding among senior management in regard to policy formulation.
- Help decision-making align with broader objectives.
- Establish a transparent system with which to evaluate performance.
- Outline and explain corporate financial risk management objectives, so those responsible may respond appropriately and confidently to unexpected changes.
What should your FX policy cover?
There’s no such thing as a one-size-fits-all foreign exchange risk management policy. An effective policy must address your organisation’s unique FX risks based on your operations and potential exposures.
However, every policy usually accounts for these 4 basic elements:
- The magnitude of foreign exchange risk your business is willing to incur
- The tools available to help mitigate said risks
- A data-driven process used to manage risk on an ongoing basis
- Long-term strategic planning decisions.
Once you create a policy, it’s important you share it with the wider team. Doing so will allow them to integrate FX risk management best practices into their duties.
Here are 3 common types of FX exposure your business may be vulnerable to:
Transaction exposure is the risk your business is exposed to when transactions are not settled quickly. Exchange rates can change between the date you agree to a purchase, and when you deliver payment. Your money may be worth less than anticipated if the exchange rate moves adversely.
For example, say a UK-based retailer agreed to buy $100,000 in goods from a US-based supplier on 12th September 2022, with payment due at the time of delivery. On that day, $1 was worth £0.8606 – an equivalent of £86,060. But because the GBP had devalued relative to the USD within a few weeks, $1 was equivalent to £0.9323 when the goods were delivered on 28th September 2022. Without a hedging strategy in place, our UK retailer had to pay £93,230 for the same goods – £7,170 more than when the order was placed.
Businesses incur translation risk when a subsidiary company translates financial statements to the parent company’s currency as a part of financial reporting. If the exchange rate fluctuates, it impacts the relative performance of the subsidiary. Translation risk is higher when parent companies denominate a significant amount of capital in foreign currency.
For example, a US-based firm suffers an operating loss of $100,000. However, its EU subsidiary reports a profit of €100,000. If this occurred when the EUR was above parity with the USD, then the EU-based subsidiary’s earnings would have negated the loss incurred by its parent company. But, if this had occurred during October of 2022, when the EUR remained below parity with the USD for much of the month, the company would have had to report a net loss.
Also known as ‘forecast risk’ or ‘operating exposure,’ economic risk results from cash flows being subject to currency fluctuations. There are many factors which may cause currency volatility. Changes in macroeconomic conditions, political instability, and government regulations are just some factors which can adversely affect a company’s market share, future cash flows and profitability.
Tips on how to create a solid FX policy
The approach to FX strategy for smaller companies does not necessarily differ from their larger counterparts. Don’t look at the market, look at your business. Learn how your business generates FX risk. Currency exchange is not an intractable problem. You can solve it with adequate planning and foresight.
Here are some tips to help you design a comprehensive FX risk management policy:
- Know your business and sources of exposure: Understanding where your sources of risk originate is as useful as knowing the market. Is the FX risk on the buying or selling side? Do you have visibility of your exposure? Is there an adequate reporting process to deliver key FX information to relevant parties in a timely manner?
- Do not trade with your ‘gut feelings’: Emotional trading is a common pitfall that many SMEs fall prey to. Your actions should always align with policy.
- Seek advice from experts: If you lack the tools or personnel, and struggle to gain visibility into potential exposures, always seek the advice of qualified professionals.
How can CurrencyTransfer help you create a robust FX policy?
Our team at CurrencyTransfer are experts in FX risk management. We’ve helped thousands of organisations from across the globe successfully navigate the difficulties of currency volatility. Don’t rely on financial forecasts to provide clarity, they’re unreliable at the best of times.
We cater to both businesses and individual customers, provide an impartial analysis of your FX exposure and safely conduct your currency trades. Below some of the tools we offer to help manage currency risk:
Rate alerts & Market orders
Rate alerts can be a useful tool to keep you informed when your target rate is reached.You can set up a rate alert for any currency pair you like for up to 30 days. Once expired, you have the option to either extend your rate alert, change your desired rate or book a trade at the current rate.
If you want to take it a step further, you can also set up market orders to automatically book the trade(s) once your target level is reached. So if it happens while you’re busy, you won’t miss out as you won’t have to do it manually. It’s a very effective execution tool that can provide you with total peace of mind.
Forward contracts are an agreement made between us and our clients, where future transactions are conducted at a fixed rate, regardless of fluctuations.
The exchange rate at the time of the deal remains the same as when the you settle the transaction. Even if the actual rate changed within that time. Forward contracts give you the ability to stay on top of your budget and plan accordingly.