CFO

Guide to Foreign Exchange Risk Management — And Why it Matters Right Now

By Megan O’Brien, Brainyard Business & Finance Editor
October 12, 2020
Lady looking up

In short:

  • As numerous international events — not just the pandemic — roil foreign exchange markets, FX risk management has risen in importance.
  • To debunk a common myth: FX risk isn’t just for big multinationals. Any company with international suppliers or customers is subject to fluctuations.
  • Hedges don’t require complicated financial vehicles. Just purchasing raw materials in the local currency is a “natural” way to cover your spread.

Indulge me in a prepandemic scenario: You touch down in an exotic foreign destination and need some walking-around cash. You avoid the beckoning, bright lights of the temptingly convenient airport currency exchange kiosks because Rick Steves told you they offer a terrible exchange rate. You’re a travel pro — no costly rookie mistakes here. To the ATM you go!

Yet when it comes to foreign exchange (FX) risk in business, we seem strangely hesitant to take measures to protect our funds — and that carries potentially much heftier penalties than exchanging dollars for dinar at a few points off prime.

In 2016, the airline EasyJet reported before-tax earnings of £495 million, a decrease of £191 million from its 2015 earnings. The British airline’s GBP operations in 34 locations across Europe and Africa had worked against it: £88 million, or almost half of the shortfall, was attributable to “unfavorable movement from foreign exchange.”

Unfavorable? That may be a slight understatement. FX risk is an oft-overlooked component of international business that can have significant impact, particularly in volatile economic times.

Case in point: Collectively, 1,200 European and North American companies surveyed in a 2018 FiREapps Currency Impact Report quantified $15.61 billion in negative currency impacts in Q3 2018. Sounds bad, right? Well, North American companies made up $11.81 billion of that loss — a 1,057% increase from the previous quarter. Political uncertainty in Europe and the United States combined with trade tensions between Beijing and Washington led to whiplash in currency markets, said Wolfgang Koester, chief executive of FiREapps.

“All that volatility came from political uncertainty,” said Koester. “We’ve never had as many CEOs and CFOs talk about currency.”

Currency risk needn’t simply be a cost of doing business internationally. You can take steps to mitigate risk and avoid losses. In this article, we discuss what constitutes FX risk, its importance in today’s marketplace and strategies to help offset the effects of currency fluctuations.

The Lowdown on FX Risk

FX risk, also known as currency risk or exchange rate risk, refers to the losses that can be incurred on international financial transactions due to fluctuating foreign currency rates. Since buyers and sellers in different countries are rarely using the same currency, the two parties must agree on what currency will be used for payment. That agreement is then subject to risks associated with exchange rate variations. Those risks can manifest in several ways.

Types of Foreign Exchange Risk

Transaction risk is faced when buying products from a company located in another country. This type of risk arises when exchange rates fluctuate during the time between entering into a contract and settling it.

Example: At press time, 1 euro is equal to 1.18 U.S. dollars. Let’s say a U.S. automaker agrees to buy €500,000 in parts from Germany with payment due at the time of delivery. That is equivalent to $590,000. However, by the time the parts are delivered, say the value of the dollar depreciated versus the Euro such that €1 = $1.22. While the price is still €500,000, the U.S. dollar amount is now $610,000.

Translation risk is incurred by a parent company that owns a subsidiary in another country when that company’s financial statements are translated to the parent company’s currency as a part of quarterly reporting. This occurs if a parent company reports a consolidated financial statement for its subsidiaries as opposed to keeping them independent. As a result, the company could experience a poor quarterly performance and, if public, a declining stock price.

Example: A firm based in Italy suffered an operating loss of €100,000. Luckily, it has a U.S. subsidiary that just made a profit of $100,000. For the sake of this example, let’s say initially €1 = $1. Now, the U.S. division’s profit nullifies Italy’s loss. Great! That will look good on reports. However, prior to the company consolidating its financial reports, the dollar drops, and now €1 = $0.86. Unfortunately, that profit is now equal to only €86,000, meaning that the company will have to report a €14,000 loss.

Economic risk, also known as “forecast risk” or “operating exposure,” is a form of long-term risk that occurs when a company’s market value and/or future cash flows are negatively impacted by exposure to currency fluctuations.

Example: A U.S. industrial machine manufacturer has operations and subsidiaries around the world. It primarily exports to Japan. However, the value of the Japanese yen unexpectedly drops against the U.S. dollar, and the circumstances driving that decline aren’t likely to change anytime soon. Now, the company has lost its competitive position in the market.

Why Does it Matter Now?

Feel like the next time someone mentions the volatility going on in the world right now, you might put your head through a wall?

Step away from flat vertical surfaces for a moment, because the global foreign exchange market is exceptionally volatile right now. And it’s not just because of the COVID-19 pandemic. Instead, particularly in the past five years, the FX market has been battered by a toxic mix of circumstances: Brexit, the U.S.-China trade war, global unrest and ensuing protests, a breakdown of NAFTA negotiations and a turbulent U.S. election, to name just a few.

fred graph

Data: Federal Reserve *10 year foreign exchange rate of multiple currencies against the dollar.

This situation has been building for some time. A pandemic was just the cherry on top of the risk sundae.

In more tranquil times, executives were able to get away with little effort around FX risk management because developed market currencies remained relatively strong and stable.

Brexit was a sharp reminder that past performance is no guarantee of future results.

In December 2017, after Brexit negotiations began to unravel, data from Bloomberg revealed that, at 9%, the pound’s realized swings against the dollar over the previous 12 months had outpaced all developed-market peers. In fact, the British pound was ranked the eighth most volatile across major emerging and advanced economies, putting it alongside currencies from Eastern Europe and Latin America.

“The British pound has more in common with the Colombian peso and the Polish zloty than you may think,” Bloomberg noted wryly.

Now that the rest of the world faces its own unique set of circumstances, experts warn that other developed-nation currencies are not immune to the same variability. Further complicating the economic outlook? The potential for a double-dip recession.

Finally, FX risk can stem from less obvious factors, according to Robin Abrams, director at Trade Finance Global. With supply chains shifting or even going offline, customs taking longer and intense swings in demand, companies may have more risk exposure than CFOs anticipated. Delays in mitigation can generate financial risk from changing FX rates.

The longer it takes to address the issue, the more exposure you have.

Long story short: There is uncertainty. And where there is uncertainty, there is volatility. The exchange markets change daily and are readily influenced by global events. The search for a vaccine, the U.K. leaving the EU, unrest in Hong Kong, the outcome of the U.S. election, COVID-19 resurgences on a global level, mitigation actions by the Federal Reserve — this is just a sampling of international events on the radar with the potential for significant impact.

Three things are clear: Even developed currencies have the potential to shift rapidly. Any uncertainty and volatility will affect foreign exchange. And businesses have lost the luxury of complacency when it comes to FX risk management.

“It’s always important to mitigate risk,” said Abrams. “But when there’s a growing increase in volatility and financial uncertainty, it is a requirement to mitigate risk.”

How to Identify FX Risks — Even When They’re Hidden

Small and midsize enterprises (SMEs) may believe FX risk is only for big multinational corporations. However, a series of reports by ACCA and Kantox on mid-caps and SMEs found that over 80% of SMEs trading internationally had experienced losses or gains due to currency fluctuations, one-third of them over $1 million.

However, instead of being proactive, according to the report, companies tend to address FX risk in a reactive way — until they suffer a major loss.

For companies that deal with customers or suppliers overseas, a good first step in a proactive FX risk management plan is to identify exposure within their organizations. While that may sound like a straightforward process, some FX exposures hide in plain sight, which can complicate identification.

A good place to start is the supply chain. Unfortunately, a quick scan isn’t going to cut it with this one. A common misconception held by companies, according to IndustryWeek, is that they do not face risk because they buy and sell only in contracts denominated in U.S. dollars. In reality, a price might actually be calculated by the supplier using the value of a different currency. Suppliers have exposure as well and often price-in that currency risk, so CFOs need a handle on how FX affects their suppliers.

Next, evaluate your company’s balance sheet and cash flow forecasts.

Identifying FX risk requires that finance teams drill down into various on-balance-sheet exposures as well as cash flow forecasts to pull out granular data about transactions that take place at the company and, as applicable, subsidiary level.

For example, a manufacturer making a major capital equipment purchase from a French firm under a contract that requires payments in euros over several years might look into FX derivatives strategies (more on that below) to help offset risk.

Lastly, an in-depth look at your business’ operating cycle can help determine the sensitivity of your profit margins to FX fluctuations and the stages of the operating cycle in which you need protection.

Unfortunately, “hedge everything” is not a strategy. It’s too time-consuming and expensive. Instead, spend some time identifying the biggest exposures in your operating cycle.

Strategies for FX Risk Mitigation

Here’s where we set the common fallacy that “currency fluctuations are just a part of doing business” to rest.

“This is a complex space, and there are a lot of strategies available to help navigate it,” said Oscar Arriaza, SVP of international banking at the Bank of Texas. “Plus, it’s something your competitors are doing. So if you’re just riding the market and hoping for the best, you’re definitely putting your company at a disadvantage. Hope is not a strategy.”

Depending on their respective pain points and business goals, there are tactics that companies can employ to lessen the impact of FX risk.

Consider Pricing and Currency Choice

One of the simpler ways to guard against fluctuations is through pricing and currency choice, particularly for ecommerce companies looking to expand internationally. There are several common approaches to consider when going global:

Keep the product in your currency: If your business prices its products in your local currency, that essentially passes the FX risk on to your customers. Your margins are secured for an amount of turnover equal to the value of the contract.

Problem solved, right? Not quite. Research by Multi-Channel Merchant shows that 25% of customers will abandon online purchases if their local currencies are not supported.

On a larger scale, Mark Way, SVP of foreign exchange at BOK Financial, recalled an incident where an oil field pipe supply company was considering purchasing a multimillion-dollar machine from Europe. Both companies insisted on completing the transaction in their local currencies. Luckily, the FX team was able to negotiate an arrangement that worked for both sides. Lesson learned: Sticking with your local currency is easy, but it could cost you opportunities.

Allow multiple currency options: This tactic appeals to a greater swath of customers, and favorable currency swings may also benefit the company. Firms selling products in the local currency can open a foreign bank account, which cuts the costs of foreign exchange. However, this strategy requires significant legwork and investment in determining appropriate pricing for different currencies, dealing with currency conversion (and its associated costs) and monitoring exchange rates. For smaller businesses, it may be worthwhile to accept only a limited number of widely used currencies to lower both risk and expense.

Build FX costs into price: Hiking costs for goods and services in foreign markets can help offset FX rate risk and volatility. However, this plan also has a downside: It can make your offering less competitive. Porsche learned this the hard way when, in the late 1980, the global carmaker decided to pass exchange rate costs to consumers through price increases — and saw sales plunge dramatically.

Incorporate Technology

For companies that rely on manual systems, like spreadsheets, trying to hedge risk can be an arduous — and error-prone — process.

Hedging decisions need to be based on accurate and up-to-date data. Because errors or time lags could result in missed opportunities or significant losses, companies managing any real volume of FX risk should look to automation. Technologies that automate most of the process make it significantly easier for CFOs to keep a closer eye on exchange rates — as well as quantify, monitor and manage the effects of currency fluctuations on their results.

From a modeling perspective, when exchange rate volatility is high and economic outlook uncertain, models like earnings at risk (EaR) and cash flow at risk (CFaR) can help manage risk more effectively.

CFaR measures possible shortfalls in cash flow due to FX rate fluctuations that could have a knock-on effect on a company’s P&L and liquidity, while EaR is the value of earnings at risk due to FX rate fluctuations.

You will need reliable data to fuel these models, but the payoff is insight into your company’s risk and the ability to quantify diversification.

Examine Your Contracts

Your current contracts may have room for improvement from an FX risk perspective.

Are you able to add protection to commercial contracts, for example? Particularly when it comes to long-term contracts, there may be an opportunity to add FX clauses to the contract that provide a refund should exchange rates deviate more than an agreed amount. Or, can you shorten the time period between a contractual agreement and payment? That will minimize the effects of major exchange rate swings.

Explore Hedging

Maybe the most familiar use of the term “hedging” is in context of “your bets” in poker. That’s not too far off: Hedging in the FX realm also refers to strategically offsetting your risk, in this case through the use of hedging instruments.

As a general example, if a U.S. company will need to pay out a large contract priced in euros in six months, it can offset FX risk using various methods and financial instruments. The idea isn’t to remove all risk, and in fact, similar to locking in any rate with a limited amount of upward or downward movement, you could end up slightly worse or slightly better off. The idea is to protect against a huge rate swing.

These methods are commonly categorized as “natural hedging” and “financial hedging.”

Natural Hedging

Natural hedging refers to a balancing act where a company adds assets that have a negative correlation. The key concept is that by allocating resources to two different asset classes, the risk arising from one asset should be offset by the return from the other and vice versa.

Essentially, the cash flow from one should cancel out the cash flow from the other.

This often entails a company shifting its operational behavior. For instance, a company with significant sales in one country can mitigate some currency risk by shifting operations to where it can also incur expenses in that same foreign currency. So if a U.S. company sells a lot of furniture in Canada, it could use that revenue to purchase wood and leather from Canadian suppliers. Because the company will not have to repatriate as much revenue, its risk is lowered.

Financial Hedging

FX derivatives are contracts to buy or sell foreign currency. These instruments are unique because the payoff depends on the foreign exchange rate. Purchasing foreign currencies when rates are in your favor can provide a valuable hedge against future weaker exchange rates.

Several types of derivatives offered by financial institutions can help companies hedge risk and even profit from FX volatility, though associated costs may offset gains.

Spot contracts: Also known as a spot transaction, spot trade, spot deal or simply spot. This is a contract to buy or sell a commodity, security or currency for immediate settlement. (Payment on the spot. Get it?) This differs from contracts like currency futures or currency forwards, where contract terms are agreed on but the actual delivery/payment occurs in the future. Instead, delivery and payment in a spot contract tend to occur within two business days after the agreement. You’re betting that the exchange rate isn’t going to change radically in two days.

Currency forwards: Aka “forwards contracts,” these are agreements between two parties that operate with different currencies, where the exchange rate is fixed, effectively locking in the rate for future payments regardless of fluctuations. So if the exchange rate at the time of the deal is €1 = $1.18, that would remain the rate when the transaction is settled, say, three months later, even if the actual rate changed within that time. The disadvantage of this strategy, though, is that it precludes you from benefiting from favorable exchange rate movements. Currency forwards are considered private contracts and are therefore essentially unregulated.

Currency futures: Aka “futures contracts,” “foreign exchange futures” or “forex futures,” this strategy specifies the price of exchanging one currency for another at a future date. Currency futures, unlike currency forwards, are standardized and thus are traded on centralized exchanges.

Currency options: Again appearing under many names — “foreign exchange option,” “FX option” and “forex option” being commonly used — this is a contract that gives the buyer the right, but not the obligation, to buy or sell currency at a specified rate on or before a specified date. For this right, a premium is paid to the seller.

Currency swaps: In this situation, the parties involved agree to exchange equivalent amounts of two different currencies at an agreed rate, then repay them at an agreed rate on a specified later date. Also referred to as a “forex swap,” “FX swap” or simply as a “swap.”

Now, all this may sound like trading gibberish. Fortunately, your financial institution or financial services provider can help determine the best strategy for your business. For extra FX protection in times of uncertainty, or for companies looking to expand internationally right now, Abrams recommends consulting with a currency specialist. Unlike banks, which provide a range of services, these professionals focus entirely on currencies.

Accounting for Hedging

There is a caveat to hedging strategies: They can make accounting difficult. So difficult, in fact, that many companies historically avoided hedging because of the headaches it caused.

However, in August 2017, the FASB issued Accounting Standards Update (ASU) 2017-12, Derivatives and Hedging (Topic 815): “Targeted improvements to accounting for hedging activities.” While the update included a hefty roster of revisions, its main provisions include:

  • Simplification and expansion of eligible hedging strategies to address financial and nonfinancial risks;
  • Improved transparency of how hedging results are presented and disclosed;
  • Increased flexibility by providing partial relief on the timing of certain aspects of hedge documentation; and
  • Elimination of the requirement to recognize hedge ineffectiveness separately in earnings.

While hedge accounting is still no walk in the park, evidence shows the process has been greatly simplified by the revisions.

Creating an FX Policy for Small-to-Midsize Companies

Antonio Rami, founder & chief growth officer of Kantox, a fintech company specializing in FX management, says the approach to FX strategy for smaller companies does not necessarily differ from its larger counterparts.

“The principles are exactly the same, which is: Don’t look at the market, look at your business,” said Rami. “It’s all about understanding how your business generates FX risk. And that’s a question I tend to not see companies asking themselves.”

In Rami’s experience, smaller firms often perceive currency exchanges as an intractable problem. He has several tips for companies to move past that trepidation and create an FX risk management strategy.

Know your business and exposure first: “You’re not an FX trader,” said Rami. “You don’t need to figure out what the market is, whether it’s high or low. You need to identify when risk starts for you.”

Is the FX risk on the buying or selling side? When will you have visibility into how much your exposure is going to be? You know that better than anyone.

Try simple mitigation before calling in the experts: Once you learn your business’ exposure, see if a simple mechanism, like increasing the selling price, can offset risk.

“Are you going to change the price if there is a change on the FX market, yes or no?” asks Rami. “If your answer is yes, then you can have a very simple strategy, which is that every time that I put a sales order, I need to create a hedge.”

Once your FX exposure becomes more complicated, or you won’t get visibility into potential exposure until later, it may be time to seek advice from experts.

Don’t overcomplicate it: “Run away from the ‘exotic products’ options,” said Rami. Instead of going for the creative products that banks build, opt for more simple ones, like spots, forwards and swaps.

Another common tactical pitfall is companies obtaining currency and executing a trade when they believe it is the “best moment.”

“If you want to gamble, currency is not the best place,” stated Rami. “It’s much easier and cheaper to gamble in a casino.”

This Isn’t Just a “Finance Problem”

For Rami, the most common pitfall he sees in FX risk management is isolating the problem to the finance department. Yes, FX is about regulations, calculations and money. But it is also a strategic topic: Whether to raise prices based on rate fluctuations or purchase some raw materials strategically are decisions that call for input from the business.

What finance leaders provide are visibility into the risks and an understanding of currency workflows. It is the responsibility of the CFO to ensure that colleagues understand the strategic significance, define a policy and decide how to execute — manually or by adding automation.

“We at Kantox believe that technology plays a huge role: If it’s mechanical, then you can automate it, and then you can get rid of the problem,” said Rami. “If you can get rid of the problem, you’re not afraid of currencies. If you’re not afraid of currencies, suddenly you are taking a problem away from your clients, because you can sell to them in their currency. If you can take the problem away from your suppliers, you will get a better price. So that’s the logic we as a company try to follow.”

Ultimately, while specific FX advice is difficult because risk is on a case-by-case basis, Rami argues that, big or small, the gist stays the same: “Understand your business, understand how you generate risk and derive a currency process you can automate.”

Bottom Line

Like planning an international trip, developing an effective FX risk management strategy for your company takes time, effort and customization. But, just like said adventure, a solid plan can help you avoid costly mistakes and discover new opportunities as your company branches out globally.

Mark Bianco

For more helpful information from the Brainyard and our friends at Grow Wire and the NetSuite Blog, visit the Business Now Resource Guide.

  

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