Questions Firms Should Ask about Financial Currency Risk During Uncertain Times
Aug 11, 2022
In order to manage FX risk effectively, treasurers need to be able to provide their CFOs with accurate and timely reports. This can be a challenge, as treasurers' roles are shifting, and they are increasingly being asked to act as advisers to their CFOs. However, by supplying their CFOs with the information they need, treasurers can help them make informed decisions about FX risk management.
Questions Firms Should Ask About Financial Currency Risk During Uncertain Times
CFOs are increasingly looking for reports that are purpose-built dashboards, making use of real-time information based on new technologies. They want to be able to use their smartphones and tablets to keep a check on their organisation’s financial status and its risk reports. Currency risk management is an example of the kind of information CFOs need in their reports.
Here is a list of questions relating to financial currency risk:
1 - What is the currency risk position from our operations – and also from our financing and investment activities?
CFOs want to see both the overall risk exposure from operations as well as its main components. This provides information on where currency risks come from, what currencies are involved, how long the risks will last, and what type of cash flow is affected. The report should be designed to be relevant to management guidelines and individual recipients’ preferences. For example, it might only include the five to seven most relevant currencies, depending on the business environment.
2 - Which measures in line with management guidelines have been taken, and how did these influence the currency risk position?
CFOs want to see how the currency risk position developed over time, considering management guidelines and the effects of risk management activities. This provides information on how the risk position has changed, how the guidelines were followed, and how the risk management activities contributed to the results.
3 - What are the main risk drivers, and how are they expected to develop?
CFOs want to understand how risks are generated and how they are expected to develop. This provides information on how the current risk position has developed and how it is expected to change in the future. It also provides information on what could trigger a change in the risk position and how this might affect the company.
4 - What are the most important currencies and risk types, and what is their expected development?
CFOs want to see information on the most important currencies and risk types and how they are expected to develop. This provides information on which currencies and risk types are most important to the company and how they are expected to develop. It also provides information on what could trigger a change in the risk position and how this might affect the company.
5 - What are the main risk drivers, and how are they expected to develop?
CFOs want to see information on the most important risk drivers and how they are expected to develop. This provides information on what could trigger a change in the risk position and how this might affect the company.
6 - What is the expected development of the currency risk position?
Finally, the CFO also needs to know what the future development of the currency risk position is expected to be. This will give an indication of what might trigger a change in the risk position and how this might affect the company.
7 - Are we within the predefined limits?
The limit framework is critical to the entire risk management process. It ensures that the risk taken by the company is within limits set by the board. The limits are set in terms of risk appetite, and they should be reviewed and approved on a regular basis.
There are different types of limits, including:
- Position limits - there are limits on the overall risk position of the company.
- Risk factor limits - these are limits on individual risk factors, such as currency risk.
- VaR limits - there are limits on the amount of loss that the company is willing to accept on a daily basis.
8 - How much risk are we taking?
It is important for the CFO to have a clear understanding of the amount of risk that the company is taking. This can be measured in terms of the VaR of the company's risk position. The VaR can be measured on a daily basis, and it should be compared to the VaR limits that have been set by the board.
9 - What is the cost of hedging?
The cost of hedging is an important consideration for the CFO. The cost of hedging can be measured in terms of the cost of the hedging instruments, the cost of the transaction costs, and the cost of the basis risk.
10 - What is the net economic value of the hedging program?
The net economic value of the hedging program is the difference between the market value of the hedged item and the cost of the hedging instruments.
What types of foreign exchange risk can I be exposed to?
There are many different types of foreign exchange risk, and hedging strategies are available to mitigate them. The three most common types of risk are:
1. Transaction risk.
This is the risk that an adverse change in exchange rates will result in a loss when you convert one currency to another to settle a transaction. For example, if you have agreed to purchase goods from a foreign supplier in Euros and the value of the Euro falls against the US dollar, you will pay more for the goods when you convert your dollars into Euros.
2. Translation risk.
This is the risk that an adverse change in exchange rates will result in a loss when converting the financial statements of a foreign subsidiary from its functional currency to the reporting currency of the parent company.
3. Economic risk.
This is the risk that an adverse change in exchange rates will result in a loss to the overall value of a company due to changes in the relative prices of goods and services.
Steps to Manage Currency Risk
1. Establish a clear risk management policy. This policy should outline the company’s objectives for managing currency risk and the tools that will be used to achieve these objectives.
2. Use hedging to offset currency risk. Hedging is the use of financial instruments to offset the risk of adverse changes in exchange rates.
3. Use forward contracts to lock in exchange rates. A forward contract is an agreement to buy or sell a currency at a fixed rate at a future date.
4. Use currency options to protect against adverse changes in exchange rates. A currency option gives the holder the right, but not the obligation, to buy or sell a currency at a fixed rate at a future date.
5. Manage exposure to currency risk. Exposure to currency risk can be managed through the use of hedging, forward contracts, and currency options.
6. Understanding the accounting for foreign currency transactions and hedging foreign currency risk can be complicated. There is a risk that accounting treatments will not be properly understood and applied, which can lead to errors and misstatements.
7. Even small errors can have a large impact on reported earnings and financial statements. Any errors that are detected should be corrected promptly.
8. Foreign currency risk can be managed effectively by developing and maintaining strong internal controls over foreign currency transactions and hedging activities.
9. Foreign currency risk can be mitigated by developing policies and procedures for hedging foreign currency risk and by entering into hedging arrangements that are designed to offset the risk.
10. Foreign currency risk should be monitored on an ongoing basis to ensure that it is being managed effectively. This involves tracking the level of risk exposure, assessing the potential impact of currency fluctuations on business operations and financial performance, and taking action to mitigate any adverse effects.
Benefits of Managing Currency Risks
1 - Protection for your cash flow and profit margins
Currency fluctuations can have a huge impact on your business's cash flow and profit margins. By managing your currency risks, you can protect your business from these fluctuations and ensure that your cash flow and profit margins are not adversely affected.
2 - A hedge against inflation
Currency risk management can also provide a hedge against inflation. If the currency in which you do business appreciates against the currency in which you invoice your customers, the prices of your goods and services will increase in terms of the currency in which your customers are invoiced. This will help to offset the impact of inflation on your business.
3 - A tool for managing your business's exposure to risk
Currency risk management can also be used as a tool for managing your business's exposure to risk. By hedging your currency risks, you can limit your business's exposure to fluctuations in the currency markets and reduce the likelihood of incurring losses as a result of these fluctuations.
4 - A source of competitive advantage
Currency risk management can also give your business a competitive advantage. If your competitors are not managing their currency risks effectively, they may be at a disadvantage when it comes to pricing their products and services in international markets. By managing your currency risks effectively, you can gain a competitive edge over your competitors.
5 - A way to diversify your business's risks
Currency risk management can also be used as a way to diversify your business's risks. By hedging your currency risks, you can diversify your business's exposure to risk and reduce the likelihood of incurring losses as a result of a single event.
6 - A tool for managing your business's financial risks
When done correctly, currency risk management can be an effective tool for managing your business's financial risks. By hedging your currency risks, you can limit your exposure to potential losses and help ensure that your business is able to weather any potential storms.
7 - Improved forecasting and budgeting
Another way currency risk management can benefit your business is by improving your forecasting and budgeting. By better understanding your currency risks, you can more accurately forecast your company's future cash flows and budget accordingly. This can help you avoid any potential financial surprises down the road.
8 - Enhanced competitiveness
Finally, currency risk management can also help enhance your business's competitiveness. By hedging your currency risks, you can level the playing field with your competitors, who may not be doing the same. This can give you a competitive edge and help you win more business.
Currency risk management is a critical part of any business's financial risk management strategy. By hedging your currency risks, you can help protect your business from potential losses and ensure that it is able to weather any potential storms.
9 - Improved borrowing capacity
The foreign exchange market is the largest and most liquid financial market in the world. This means that when you hedge your currency risks, you can often borrow at a lower cost than if you did not hedge your risks. This can be a critical factor in ensuring that your business has the financial resources it needs to grow.
10 - Improved profitability
By hedging your currency risks, you can protect your business from potential losses. This can help to improve your business's profitability and ensure that it is able to weather any potential storms.
What Is Natural Hedging?
Natural hedging is a type of hedging that involves using a company's existing assets to protect itself from currency fluctuations. For example, if a company exports goods to a foreign country, it may use its inventory of those goods as a natural hedge against a depreciating currency. If the value of the currency decreases, the company can still sell its goods for the same price in terms of the foreign currency, meaning that it will make a profit.
When you are managing currency risk, there are a few things that you need to keep in mind. First, you need to be aware of the different types of risk that can affect your currency exposure. These include political risk, economic risk, and financial risk. Second, you need to have a plan in place for how you will manage these risks. This may include hedging your exposure or using financial instruments to protect against losses. Finally, you need to monitor your exposures and make sure that your risk management strategy is working as planned.
If you are looking for ways to help manage your currency risk, start using the Bound platform today! Bound is the auto hedging platform dedicated to making currency protection better for businesses.