Businesses of all sizes have ready access to most global markets and engage in activities such as exporting or importing goods, establishing a foreign branch, or holding an equity investment in a foreign company. A company conducting business abroad faces the risk that fluctuations in the exchange rate between the domestic and the foreign currencies involved will affect the cash flows of the enterprise, its profitability and even its solvency.
Chief financial officers (CFOs) and treasurers should be concerned with eliminating volatile currency risk and its effect on earnings while considering the economic factors. In fact, by employing effective foreign exchange (FX) risk management, an organisation will reduce its costs, enhance revenues and mitigate the inherent risks of conducting business in foreign currencies.
As a general rule, the more currencies involved and the longer the time period before settlement, the more complex it becomes to manage the FX risk. Normally, the more the proportion of foreign currency exposure relative to the domestic currency, the larger the actual risk is.
Ultimately, the decision to hedge foreign currency exposure and risk is based on weighing the costs and benefits of alternative strategies. Yet before this can be done, it is important to understand the different classes of FX exposure.
Classes of FX Exposure
There are three distinct classes of FX exposure: anticipatory, transactional and translation.
- Anticipatory risk is the operating risk against forecasted transactions that are denominated in currencies other than the organisation’s or business unit’s functional currency. This measures changes in the value of the firm that result from changes in future operating cash flows caused by unexpected changes in exchange rates. The changes in value depend on the effects of exchange rate changes on future sales volume, prices and costs, which can have a profound effect on an organisation’s competitive position. Forward contracts and options are common tools used to hedge anticipatory risk. Using a forward contract locks in an exchange rate for a transaction that will occur in the future. An option sets a rate at which the company may choose to exchange currencies. If the current exchange rate is more favourable, then the company would not exercise this option.
- Transactional risk takes a closer look at an organisation’s profit and loss (P&L) risk due to the changes in exchange rates between the recording of a transaction on the balance sheet and its settlement. This is an uncertain domestic currency value of cash flows, which are known and fixed in a foreign currency. The only source of uncertainty is the future exchange rate. Transaction exposure can be hedged by contractual tools such as forwards, futures, options and money market tools. Others include operating strategies (i.e. leads and lags) and back-to-back loans, parallel loans, currency swaps and credit swaps.
- Translation risk exists when functional currency assets exceed liabilities. Examples include the translation of investment in subsidiaries at the current versus historical rate, or translation of subsidiary earnings at the current versus forecasted rate. The main technique to minimise translation exposure is called ‘balance sheet hedge’ and it requires an equal amount of exposed foreign currency assets and liabilities on a company’s consolidated balance sheet. If this can be accomplished for each foreign currency, net translation exposure will be zero.
Aligning with Corporate Objectives
One of the biggest mistakes that a treasurer or a finance department can make is in not working closely with their business units to look at their exposures holistically.
Regardless of the type of FX risk exposure, it is important to ensure the risk management strategy is in alignment with the business’ overall objectives. That also means insulating the company from cash flow risk, which could jeopardise its ability to pursue its strategic imperatives.
Analysing the Available Data
Although FX risk management can be a tedious and manual process, it is important to understand your currency risk and implement ways to monitor those exposures. FX risk management is one of the most difficult jobs in finance, due to data integrity. Thus analysis of the available data is the most critical component of hedging.
Fundamental analysis focuses on key economic data and political news to determine the direction of a currency’s value. All currency markets are interrelated and will assist in making better decisions regarding the directions of the economy by knowing the current events driving the FX market. Risk appetite, global equity and commodity markets also impact the FX market, especially in countries experiencing investment inflows and outflows. Other components of fundamental analysis include monetary policy decisions, the interest rate market and changes in legislation with respect to taxation and regulation.
Some companies may adopt a comprehensive system of risk management, particularly where the extent of exposure is large, or where management has a defensive attitude to risk. A comprehensive risk and impact analysis should consider economic, compliance and operational factors.
However, where the costs of a comprehensive risk management strategy outweigh the benefits because the extent of exposure is small, or where management chooses to adopt a speculative approach to exchange rate movements, it is important to proactively set your hedging guidelines in response to what is going on in the market, and to have a vehicle in place by which those guidelines can be approved quickly at the appropriate level in your organisation.
Setting Hedging Policy
Once the risks have been identified and assessed, the next consideration is to determine which hedge strategy better enables a company to achieve its strategic objectives within their risk appetite. When this is determined, it is important for a company to set its hedging policy based on those objectives. Once the hedge strategy has been determined, the creation of the policy should be straightforward as it should clearly articulate the strategy in terms of what instruments can be used, who has authority over such instruments, segregation of duties and how the policy will be managed and controlled, including reporting to senior managers and the board.
Having sound FX strategies in place is critical to the success of a global business. Use the data that is available to you to choose the type(s) of FX hedging that best aligns with your organisation’s objectives.
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