How to Manage Foreign Exchange Risk
Currency exchange is the risk that future movements in exchange rates will have a material adverse impact on the position of your business. Many factors may trigger currency vulnerability, so it is essential to consult an expert—possibly at your bank—to determine how exposed your business is.
Recent wild swings in global currency rates have made exchange rate risk a hot topic for companies with customers, suppliers, or production overseas. With these dramatic changes, businesses of all sizes are aware of how much currency risk they are exposed to. For example, NOK, SEK, AUD, NZD and emerging market currencies have suffered from recent fluctuations in value; however, some of this loss has been recovered since April.
The impact of exchange-rate fluctuations can also be seen in the large numbers of companies that have hedged, or locked in, their currency exposure. The frequency and use of currency hedging have increased in the last 12 months to protect against future currency movements.
In the meantime, companies willing to take on more risk in a high-growth market have been taking advantage of some of these currency opportunities, such as retailers buying local inventory at low rates. There are several ways to carry out FX hedging.
Currency Exchange Risk
Before we discuss the different methods of FX hedging, let us talk about foreign exchange risk. Foreign exchange risk is an organisation's exposure during currency exchange rates change. Exchange rates, set by money trading services, change all the time, so an organisation may need to adjust its practices to continue making a profit.
Essentially, any situation in which an organisation uses foreign currency can be considered a foreign exchange risk. However, companies that deal with multiple currencies are more prone to foreign exchange risk than their counterparts that deal in a single currency. It is why FX hedging is essential.
Many companies in the energy and mining industries find themselves under long-term contracts lasting many years. These organisations often receive income in foreign currency and hold offshore assets, possibly in a different currency than the companies. Contract prices are usually set in another currency, making it impossible for corporations to take advantage of fluctuating exchange rates.
Here are a few risks involved:
Income (including interest, dividend, royalties) and revenue in foreign currency
Payments to suppliers (made in foreign currency)
Business loans made in foreign currency
Holding offshore assets
The simplest way to lessen the risk is to buy and sell the currency. Unfortunately, many companies are wary of the currency markets after the financial crisis of 2008. Other ways include borrowing money, FX hedging and employing a currency peg.
Highly competitive companies selling high-quality products or services with a reputation for exceptional quality may transact with almost anyone in almost any currency. For example, a US company may sell its products abroad for USD even in another country. Doing this cuts exchange risk.
In practice, this may be difficult since certain costs must be paid in local currency, such as taxes and salaries. A company that transacts business online may avoid such charges.
Whether in the energy or mining industries, many companies, or even those working on large construction projects such as power plants, pipelines and wells, often find themselves under long-term contracts lasting many years. During this time, fluctuations in the currency market may make it impossible for the company to profit due to the set price being written in a different currency.
To get around this problem, some companies may wish to include an exchange rate clause in the contract that allows that company to claw back its losses if the currency exchange rate deviates more than an agreed amount. It passes any foreign exchange risk onto the customer/supplier and will need to be negotiated like any other contract clause.
Another way to protect against this is to buy a forward contract. These are written in USD to be sure of the price and, therefore, profit potential. The company will not make as much profit if the USD is weak, but it will not lose out if the USD is strong.
Companies in the import/export business must deal with the risk of exchange rates fluctuating between the time the product leaves the company and when it arrives at the destination. There are several ways that this risk can be mitigated. Companies can choose to use export credit insurance, which is paid for by the buyer of the product. The insurance covers the risk of the exchange rates changing so that the seller is not left unable to pay the agreed-upon price.
There are also other FX hedging strategies available to the companies, which can effectively lock in an exchange rate, and therefore the price, at the time of the trade. Spot contracts are highly versatile and can lock in forward contracts or specific currencies. They are a great way to manage currency risk.
Companies can also opt to use currency swaps. These allow companies to exchange different currency debts to fix the interest rates. This strategy can be helpful if one of the companies is looking to expand their business but is short of cash.
They can exchange the debt for a different currency from that of the other company and then agree to exchange the amount back later. Again, this agreement would aim to reduce the risk of exchange rates changing by taking advantage of the interest rate differential.
Another option would be to use futures contracts, allowing companies to buy a currency at a future date at a fixed price. It is done hoping that they can take advantage of a currency that’s expected to rise. If the cost of the money increases, they can then sell the currency back at a profit.
These can be an efficient method of protecting against foreign exchange unpredictability. It requires legal expertise to ensure that the contract is fool-proof. The indices against which the currency exchange are set should be clearly stated. These clauses also require that the finance and commercial teams implement a regular review rigour to ensure that the necessary recoup of the loss is actioned once an exchange rate clause is triggered.
FX hedging naturally occurs when a company minimises its currency risk in foreign exchange by matching revenues to costs abroad. For example, a US company operating in Europe and generating revenue in Euros may look to source products from Europe for supply into its US business to use these Euros. Doing this creates a natural hedge.
Conversely, a US company exporting to Europe may look to purchase local costs (such as labour and materials) in Euros to input into its US retail business. It also creates a natural hedge.
If the Euro depreciates against the US dollar, the US company could purchase the products using fewer US dollars than initially. Currency hedging can also occur through the offsetting of cash flows or by matching cash inflows to outflows. Financial experts call this net investment hedging.
Companies that produce or consume commodities will hedge against exchange rate volatility to find and pay them at a single cost of the underlying currency. By offsetting two risks and spreading the price, the company can benefit from cost stability and a better profit margin.
FX hedging can also be used as a long-term strategic decision. For example, a company may invest overseas and cover the currency risk. It could hedge against currency fluctuations in the future based on the current exchange rate.
Why Is Risk Mitigation Necessary
Meanwhile, other companies have chosen to let the currency markets take their course in the short term and accept the losses and carry on.
On the other hand, organisations with obligations denominated in another currency have to either borrow the currency at what could be an expensive cost or hedge the risk by finding a way to offset the currency exposure, such as by buying a currency option.
The currency rates of many emerging nations are of particular concern because they are volatile, and their central banks can be reluctant to intervene. The currencies of these emerging markets are all suffering. The Turkish lira has devalued. The South African rand and the Mexican peso also decreased value. Although these bits of information are a few months old, these nations' market situations have not changed.
It is still a worrying scenario for the companies in those nations. Expensive currencies could be dangerous for the economies of emerging countries because the local companies will lose their competitiveness. And the central banks of these nations are aware of this.
The Bank of Turkey has stated that the currency will not weaken significantly, and The Bank of Mexico has said it will try to prevent the peso from weakening too much. In these situations, companies have to hedge the risk or find a new way to conduct transactions.
For example, Turkish companies took advantage of the appreciation of the Euro against the lira to hedge their costs against the lira. In Mexico, a similar strategy is being used to protect the value of their cash against the peso falling. If the currency falls too much, it is difficult for the companies to pay their employees' salaries.
The volatility of emerging currencies can create several problems for companies in these nations. High volatility rates can make it difficult to budget and plan as the values of the currencies are changing every day. It can even make it hard to do the daily transactions necessary for a company, but it is still not a reason to panic.
It does not mean that all the companies in these nations will close, but it is vital to have the proper knowledge in these situations. For example, it is easy for companies to protect against peso devaluation in Mexico. In other nations, it could be more challenging. But still, it is always a good idea to make sure that the company's finances are as stable as possible.
Currently, the companies in these nations have to adjust to the situation. It is a complex task, and their actions can have long-term effects. But hedge funds are responding and adapting to the problem. The Turkish lira, the South African rand and the Mexican peso are all strengthening, so it looks like hedge funds and the companies in these nations will have to adapt.
Companies with solid relationships with suppliers and customers should not be afraid of foreign currencies. They should be aware of the risks and know what to do to minimise the damage of any losses. If an organisation plans, they may protect themselves against ever having to breach their contract due to currency volatility.
The world has experienced the most significant changes in exchange rates in the last fifty years. As a result, the future will likely bring continued volatility. In other words, this means that companies will have to do more to protect themselves from currency risk.
These lessons are essential for those working in international markets. We should never forget that it is not always necessary to take advantage of currency fluctuations. Many companies choose not to participate in currency markets. The reason is that they are aware of the risks and are not willing to pay the price involved.
However, if a company is not active in currency markets, it should not be afraid. It is best to stick to products or services and avoid the risks of currency trading. It is not enough to realise that currency risk exists.
Companies must be prepared to find the best way to protect themselves against the risks. They should be well-prepared before any of the risks lead to a situation in which they cannot fulfil their obligations.
If a company can restructure its business strategy, it may reduce its dependence on foreign currency. It means that the entity would have a stronger position to negotiate with suppliers and customers. It is not a good idea for an organisation to wait for the risk of currency loss to become a reality before it acts.
Learn more about our corporate finance and FX hedging services at Bound. We are a company that provides a hedging platform to protect your business from currency fluctuation. Book an appointment now to learn more about our services.