Why You Should Budget For an FX Risk Management Solution
Apr 13, 2022
Treasurers who have a strong knowledge of foreign exchange risk management are invaluable to their companies, particularly when it comes to addressing the concerns of investors. In the annual reports filed by large multinational companies, there is a section requiring disclosure of the company’s exposure to various foreign exchange risks.
This section can help investors and analysts to analyze a company’s risk exposure, the management’s strategy and the effectiveness of the strategy in managing the risks. Additionally, it is also useful in analyzing the company’s ability to deal with foreign exchange risks and the overall financial position.
In addition, the section also analyzes the volatility of the asset and liabilities. It is crucial for treasurers to understand the implications of the volatility of an asset or liability on the balance sheet. Therefore, the treasurer should consider the following issues and questions when analyzing foreign exchange risk:
The Importance of Analyzing FX Risks for Businesses
Companies have a keen interest in forecasting the future movements of foreign exchange rates because of their significant impact on profits. Forecasting exchange rate levels and movements are, however, a difficult task. A number of pitfalls can cause inaccurate forecasts, including:
Since exchange rate movements are largely unpredictable, the above led some companies to make no provision for foreign exchange risk. This, however, may put a company at risk. The lack of a provision may lead to a situation where a company is unable to meet its financial obligations because of changes in the exchange rate between the time of the transaction and the time of settlement.
Different Ways to Mitigate the Impact of FX Risks on Businesses
Tip #1: Hedge Your Operations in the Pre-Trading Stage
When it comes to hedging operations, it is preferable to do so in the pre-trading stage, instead of the pre-payment stage. This would allow the company to lock in the exchange rate at an advantageous rate.
For example, a company decides to import goods from Thailand in the coming three months. The company will benefit from the favourable exchange rate at the time of import and will bear the burden of a worse exchange rate when paying for the goods.
Instead, the company could have converted the payment into Thai Baht using the current exchange rate and pay the company in Thai Baht.
The best way to make informative decisions as a treasurer is to gain deeper insights into hedging, which involves exploring hedging instruments such as NDF futures contracts, forwards, options, swaps, and more. This can help clarify the complexities of your economic reports and figure out the best options for mitigating the company’s foreign exchange risks.
Why is Foreign Exchange Hedging Beneficial?
There are two major reasons foreign exchange hedging is beneficial.
First, it allows a company to lock in the exchange rate at a favourable rate. If a company enters into a contract to buy goods in future, they will benefit from the favourable exchange rate at the time of import and bear the burden of a worse exchange rate when paying for the goods.
Instead, the company could have converted the payment into foreign currency using the current exchange rate, and pay the company in foreign currency.
Second, it allows a company to avoid the risk of losses due to the adverse exchange rate movement. After filling in the blanks in the foreign exchange risk management form, we are able to complete the form and make decisions about foreign exchange risk management.
Foreign exchange risk management is a very important part of the business. It will help the company avoid financial risk and improve its financial position.
Hedging Practices Against Commodities
Not all companies are exposed to FX rates. With that in mind, a company can also trade in the commodities market, which can either be done on an exchange or OTC (over the counter). In trading, the company expects a profit from the change in the price of the goods between the time of purchasing goods (or entering into a contract to buy goods) and the time of selling the goods.
Here are some things to consider:
Pricing risks: The company has to decide the price of its products at the time of sales. If the exchange rates change before the sales, the company may face a loss. Hedging practices can help the company to fix the selling price of the product and avoid the risks of fluctuating prices.
Risk of counterparty default:
In the case of commodities like oil, a company can make a deal with the customer and pay them in foreign currency after the transaction. But the company is not certain that the customer will pay them in time. This can lead to a risk of counterparty default. On that note, hedging practices can help the company to reduce this risk.
Tip #2: Reassess Your Company's Operating Cycle
Businesses generally face two types of exposure to foreign exchange risks:
Direct exposure: The exposure of a company to foreign exchange risks due to transactions for the purchase of goods and services, and sales of goods and services
Indirect exposure: The exposure of a company to foreign exchange risks due to the financing it has undertaken for its domestic operations
In order to minimize foreign exchange risks and improve the company's financial position, it is important for the treasurer to reassess the company's operating cycle. This is particularly important when a company's operating cycle is long.
Tip #3: Understand that Every Business has Distinct Currency Flows
The impact of foreign exchange risks can be unfeasible and unpredictable. Besides that, it will also take away valued resources from your business. Therefore, it is crucial to understand the importance of assessing foreign exchange risks and make conservative decisions to mitigate the risks.
Understanding the distinct currency flows can help the treasurer in the following ways:
Understanding the Company's Currency Exposure - This can help the company manage the foreign exchange risks and improve its financial position.
Understanding the Company's Overall Financial Position - assessing the company's currency flows can help the company manage the risks and enhance its financial position.
Understand the Impact of Foreign Exchange Risks on the Company's Operations - by accepting the shifts in currency flows, it can help the treasurer to better comprehend the reasons behind the changes in the company's operations.
Tip #4: Consider the Different Rules to Consider for Your FX Risk Management, and Be Sure to Strictly Follow Them
When it comes to foreign exchange risk management, different companies follow different rules. The only difference is in the way the rules are being followed.
Some companies follow the rules as written in their foreign exchange risk policy, and some companies follow the rules based on their needs. A company will be more successful in mitigating its foreign exchange risk when it follows the rules as written in its foreign exchange risk policy. Such companies will be able to manage their foreign exchange risks better.
However, it is crucial for companies to understand the rules and have a clear understanding of the risks involved before they follow the rules.
Tip #5: Know and Manage Your Business's Exposure to FX Risks
Toward the end of the foreign exchange risk management process, it is crucial for the treasurer to assess the business's exposure to foreign exchange risks. This can help the company manage the risks and reduce the financial risks involved.
There are two indicators that can be used to assess the company’s foreign exchange exposure:
Long-Term Exposure - Companies that have a significant amount of assets or liabilities that are exposed to foreign exchange risks for a long period of time will have high long-term exposure to foreign exchange risks.
Short-Term Exposure - Companies that have a significant amount of assets or liabilities that are exposed to foreign exchange risks for a short period of time will have high short-term exposure to foreign exchange risks.
Be cautious of foreign exchange risks and have a clear understanding of the risks involved. Once the risks have been assessed, it is important to cut down on these risks.
How Does FX Risk Management as the Treasurer Help Steer Your Business to Success?
The risks involved with the foreign exchange are very significant, so it is crucial for a company to devise a sound foreign exchange risk management strategy. With this, a business can gain a competitive advantage in more ways than one.
Benefit #1: Secure Market Margins
A company with a powerful foreign exchange risk management strategy can secure a competitive advantage in the market; this will allow them to increase the margins of its products. When companies with better margins are making fewer profits, it is impossible for them to develop.
Benefit #2: Optimise Cash Flow Estimates
It is crucial for a company to have the ability to estimate cash flow estimations in foreign currency. This will help assess whether there is a need to hedge the market and will help keep the company from having financial losses. Cash flow estimates are crucial for a company to run smoothly and maintain financial stability.
Benefit #3: Mitigate Speculations on Exchange Rate Trends
When a company has a deep understanding of foreign exchange risk management, it will be able to avoid speculations on exchange rate trends. This will help the company better manage the business and will help protect the company from undesirable losses.
Benefit #4: Improve Financial Forecasting and Budgeting
Foreign exchange risks can have a significant impact on a company's financial position. In order to avoid the risks, it is crucial for the treasurer to ascertain the impact of the risk in the company's financial forecast and budgeting. This will help the treasurer determine the extent of foreign exchange risks.
When companies make their decisions based on their financial forecasts, they tend to be more successful than those who make decisions based on their gut feeling.
Benefit #5: Stay on Top of How Fluctuations Impact the Company's Balance Sheet
Foreign exchange risks have a significant impact on a company’s balance sheet. For a company to stay on top of how foreign exchange risks impact their company's balance sheet, it is crucial for the treasurer to consider the following:
Changes in working capital – Foreign exchange risk management has a direct impact on a company’s working capital. For example, a company's inventory price increases due to the hike in foreign exchange rates. This can result in a significant increase in the company's working capital.
Changes in assets and liabilities - Foreign exchange risk management has a direct impact on the company’s assets and liabilities. For example, a company imports goods and services from its overseas partner. If the company's foreign exchange rates decrease, it is possible that the company won't be able to pay its partner the full amount.
Benefit #6: Increase the Company's Borrowing Capacity
When companies have a solid foreign exchange risk management strategy, they will have a competitive advantage in the market; this will allow them to raise more debt capital.
Raising debt capital will help the company expand their operations and improve the company's financial position. A company's foreign exchange risks will have a direct impact on its financial position and overall success in the market. It is crucial for the treasurer to assess the risks involved and devise a sound strategy.
At the end, when all the risks involved are mitigated and the risks are being managed, the company will benefit in the following ways:
Improved financial position.
Increased value of the company.
Better market share.
Better borrowing capacity.
Better cash flow forecasts.
Better appreciation of assets and liabilities.
The company will have more control over the company's cash flow and financial position.
The Bottom Line: The Pivotal Role of Budgeting to Optimise Your FX Risk Management Solutions
A company that has a better understanding of foreign exchange risk management will be able to reduce the risk involved in the foreign exchange market and will be able to manage the risk involved.
Based on the knowledge they have of foreign exchange risks and the impact they can have on the company's financial position, they will be able to develop better strategies to mitigate their risks.
How Can We Help You?
Bound is an auto hedging platform designed to make currency protection better and more effective for various industries. If you're interested in ,currency protection for businesses, reach out to us today!
With Bound, you can effectively manage your FX risk and generate greater returns with a layered hedging strategy. Our platform allows you to quickly access the market and analyze your potential profit at any given time. You can make adjustments to your pricing strategy to fit your needs and protect your risk exposure.