Managing FX Risk in Times of Uncertainty
Aug 3, 2022
Indulge me in a hypothetical scenario wherein an epidemic has yet to arise: You step off the plane in an exotic foreign country, and you need some funds. You avoid the temptation to use the convenient kiosks at the airport that offer exchanges at terrible rates. You won’t make a rookie mistake! You rush to the nearest ATM. Yet when it comes to foreign exchange risk in business, we seem strangely reluctant to take measures to protect our funds — and that comes with much higher consequences than exchanging dollars for dinars at a few points off prime.
Managing FX Risk in Times of Uncertainty
Let’s step back for a minute and define what we’re talking about when we say foreign exchange risk. Foreign exchange risk is a statistical probability that changes in exchange rates will cause a decline in the value of the firm. Most companies plan to grow and expand through an international presence. As they build their business, they actively pursue new markets or opportunities in other regions.
Those risks can manifest in several ways:
1 - Economic Risk
There are many things that can go wrong around the world and affect your business. For example, you could face currency devaluation or inflation in your home country that affects your sales. You could also face some bad policy decisions from officials you don’t vote for.
Or, perhaps your company is doing so well that it attracts the attention of a foreign country’s economic interests. That could lead to a trade war that can affect your import/export business or an economic embargo that can hurt your local business.
2 - Commercial Risk
Another risk is that you have partners and suppliers around the world. Those relationships also expose you to risk. There are things that can affect their ability to provide goods and services to meet your needs. For example, bad policy decisions, sanctions, or a currency devaluation could leave you without the supplies you need to make your product or service.
3 - Transaction Risk
Perhaps you are trying to sell your products or services abroad, and the foreign exchange rate is not in your favor. Or, you might be buying products from abroad, and the foreign exchange rate is not in your favor. Either way that could have a direct impact on your business.
Risks can come from a variety of sources and can magnify the damage over time. How can you protect your business from those risks?
1 - Keep the product in your currency
This is the first rule. When your company is planning its international expansion, ensure that the product itself is in the same currency as the country you are expanding to. This way, you have no foreign exchange risk. Even if your customers use a different currency for their accounts, you can still receive payments in your home currency.
2 - Collateralize it
If you want to make a purchase in a foreign country and you would like to hedge your risk, but you don’t want to tie up your capital, you can use an FX forward contract as collateral for a bank loan. The loan will go toward the purchase, and the interest on the loan will go toward the FX forward contract.
3 - Buy protection
The other option is to buy protection. You can buy insurance against the adverse effects of currency fluctuations. For example, you could buy a foreign exchange option to protect yourself against the risk of currency devaluation.
4 - Pay up-front
If you are making a payment to a supplier based in a foreign country, the payment likely won’t be made in local currency. In this case, you must convert the payment to a foreign currency. However, you can do this in advance. If you pay your supplier several months or even years in advance, you don’t run the risk that the price of your payment currency will change.
5 - Hedge it
A fifth option is to engage in hedging. A lot of companies that operate abroad use hedging to manage their risk. The idea is that you can choose to pay in your home currency, or you can use a forward contract to hedge your risk. There are other hedging techniques you can use.
How to Identify FX Risks
Most companies don’t realize that they have foreign exchange risks. If you don’t understand your exposure, how can you figure out what to do about it?
Begin by looking at all of your transactions to identify where you have exposure. For example, is your company buying raw materials or equipment abroad? Or, is your company selling your products or services abroad?
Your next step is to look at your accounts receivable and accounts payable to identify the currencies in play. Then compare those accounts to your company’s revenue and expenses to identify the impact of your foreign exchange risk on your financial statements.
Finally, you want to look at your cash flow statements to see how your foreign exchange risk affects your cash flow. If you are on the asset side of the equation, you should see an increase in the value of your accounts receivable and an increase in accounts payable. If you are on the liability side of the equation, you should see a decrease in the value of accounts payable and a decrease in accounts receivable.
The more you understand your risk, the more you can plan for it.
Exploring the Hedging Option
The best hedging technique is the one that fits the needs of your company.
Is your company looking to expand internationally and make a large purchase? If that is the case, you can use a forward contract to hedge your risk. If you already have a forward contract in place, you don’t need to worry about future volatility. You can just let your contract expire and consider the contract expired.
If your company is already operating abroad, then you might have a forward contract in place. You might also have a currency option or a currency swap, or a combination of those. In this case, you could use your forward contract or your currency option, or currency swap to hedge your risks.
Of course, if you are running a 5-person company and you aren’t making any large purchases or selling products abroad, then you don’t need any hedging. You can just wait for your forward contract to expire.
There are several hedging options you can consider. Here is a list of them.
1 - Natural Hedging
Your first option is natural hedging. Natural hedging is an option that is built into your business plan. For example, if you set up a manufacturing business in a foreign country, you can set up a supply chain that uses local labor and uses local materials. You can pay your local suppliers in local currency, and you can even get paid in local currency. This way, you don’t need to worry about foreign exchange risk. You can just let the currency fluctuations work out in your favor.
2 - Financial Hedging
Your next option is financial hedging. Financial hedging is an option that you can buy. Financial hedging options include forward contracts, currency options, currency swaps, cross-currency basis swaps, and cross-currency interest rate swaps. These strategies reduce the exposure from your foreign exchange risk.
3 - Commercial Hedging
Your third option is commercial hedging. Commercial hedging is an option that your business partners can use. In fact, if a supplier is in a foreign country, they can use financial hedging. If a buyer is in a foreign country, they can use financial hedging.
4 - Operational Hedging
Your final option is operational hedging. This is when you go ahead and take on the risk yourself. For example, if you are making a large purchase, you could pay your supplier in advance. That way, you would always have to pay the same price — even if the currency movements hurt you.
Several types of derivatives that help companies hedge risk
1 - Spot contracts
A spot contract is a contract that concludes with the sale and purchase of an asset or the sale and purchase of a liability. In other words, the spot contract is concluded at the present time. A spot contract does not mature in the future and does not have any need to pay interest.
2 - Currency futures
A currency future is a contract to buy or sell a fixed amount of a particular currency at a fixed price on a particular date. The payment is made in the currency of the buyer.
3 - Currency options
A currency option is an option to buy or sell a fixed amount of a particular currency at a fixed price on a particular date. The payment is made in the currency of the buyer.
4 - Interest rate futures
An interest-rate future is a financial contract that gives the buyer the right to receive the difference between a specified interest rate and a rate set at the time of the transaction, multiplied by the amount of money the buyer transfers. An interest-rate future is bought or sold on the same conditions as any other future.
5 - Forward contracts
An interest-rate forward contract is an agreement between two parties to exchange one currency for another currency at a specified exchange rate on a specific date.
6 - Cross-currency basis
A cross-currency basis swap is a contract that provides exchange rate protection to a counterparty in exchange for interest rate payments. A cross-currency basis swap is intended to provide a counterparty exchange rate protection against adverse movements in the exchange rates.
Accounting for Hedging
When you hedge your foreign exchange risk, you still have to report your financial results. But, you need to do it in a different way. This can get a little bit tricky, but you have to report your results in the currency of your home office for your revenue and in the currency of your foreign operations for your expenses.
For example, if you have a subsidiary in Brazil, you use the Brazilian real to report revenue and expenses. If you use euros to pay your Brazilian subsidiary, you’ll report your revenue and expenses in Brazilian real. If you use the euro to pay a supplier in Brazil, you’ll report the revenue and the expenses in euros.
If you are using a forward contract, you still have to report the revenue and expenses. But you have to report revenue and expenses in the currency of the underlying transaction.
Why Selecting the Right Hedging Platform Is Crucial
The reality is that you have a lot of different options for hedging your risk. You can use forward contracts, currency swaps, currency options, or even cross-currency basis swaps and cross-currency interest rate swaps. You can buy these hedging products from an investment bank, or you can buy them directly.
The trick is to pick a hedging strategy that works best for your company.
But don’t forget that you also have to pick a hedging platform. How can you do that?
You have to start by identifying the factors that matter most to you. Do you want to use an investment bank or an online trading platform? Are you going to want to buy contracts that mature in a few days, or are you going to seek longer-term contracts that mature a year in the future? Are you going to want to use leverage?
Once you have identified the factors that matter to you, you will have a better idea of which platform fits with your risk profile.
Foreign exchange risk is a risk that every business owner needs to understand. If your business is looking to expand overseas, you need to understand how foreign exchange risk affects your business. If your business is already operating in foreign countries, you need to understand how foreign exchange risk affects your business.
If you need forex hedging for businesses, the Bound platform can help! Bound is an auto hedging platform dedicated to making currency protection better for businesses. Get a fatter bottom line today by using Bound!