For these reasons, firms have a business need to manage their foreign exchange exposure and to deal effectively with foreign exchange risks. The risks that banks and corporations face from foreign exchange rates are not the same, and they manage them differently.
A corporation's foreign exchange position is called its 'foreign exchange risk' or FX risk. It is the risk that, over time, the value of a foreign currency will appreciate or depreciate against the home currency so that revenues and income will shrink or grow.
Companies should take the right measures to address the risks they face due to foreign exchange rates. In order to manage foreign exchange risks, companies should assess the market risks. This can be done by analyzing the flow of funds, market changes, and operational issues.
The Basics of Foreign Exchange and Its Impact on Several Industries
When the exchange rate increases, the price of the imported goods and services also increases, reducing their demand and their sales in the long run. This leads to a decline in the sales of the importers, a fall in their share prices, and a decline in their wealth.
Because they are purchasing fewer imports, they are sending fewer U.S. dollars abroad, which depresses the dollar further. The exchange rate will eventually settle at a new level, but it will probably be lower than it was before.
Why is Managing Foreign Exchange Risks Critical in More Ways than One?
As a result of the increase in global trade, most companies have exposure to foreign currency risk. For example, a company that markets its products in Europe may sell them for €1.00, but the cost of producing those products may be $1.50. The company will collect €1.00 from the customer while paying $1.50 to its European suppliers. If the U.S. dollar declines in value against the Euro, the company will be making less money than before.
Companies also need to be concerned about the effect of foreign exchange risk on their cash flow. A corporation's exposure to foreign exchange risk is called its foreign exchange position, which reflects the gains and losses due to changes in exchange rates.
A company's foreign exchange position determines its exposure to foreign exchange rate movements, usually beyond its immediate control. Exposure to exchange rate movements can result in sporadic, unexpected gains and losses. In other words, exposure to foreign exchange risk interferes with the cash flow management of most companies.
To that end, the need for a solid foreign exchange risk management strategy is crucial in any company's long-term success.
Different Ways to Measure Foreign Exchange Risks: Traditional vs Digital
An understanding of foreign exchange risk measurement is crucial to calculating a company’s foreign exchange position. The company's foreign exchange position determines the impact of foreign exchange rate movements on the company's balance sheet and income statement.
FX Risk Measurement Using a Balance Sheet or Income Sheet
The value of a firm's assets will change as a result of foreign exchange rate changes, which will affect the firm's income statement, as well as its balance sheet. How a firm manages its income statement and balance sheet determines the company's foreign exchange position.
The income statement, which is prepared for the year, is the difference between the revenue and expenses for that year. The balance sheet, which is prepared at the end of the year, is a summary of the company’s assets, liabilities, and shareholders' equity. The balance sheet shows the value of a company’s assets and liabilities in a specific currency.
In essence, using a balance sheet or an income sheet puts the focus on your transactional risks, which are the risks involved when you conduct a transaction with another company in a foreign currency. They also include risks when a company uses a foreign currency loan or invests in a foreign currency-denominated bond.
FX Risk Measurement Using Hedging or Hedged Statements
Hedging is the process of using forward contracts, options, or futures to protect against your foreign exchange risk. These instruments must be used in a hedging strategy that is linked to your income statement, not the balance sheet.
Hedging instruments are derivatives, which are financial instruments whose inherent value depends on an underlying asset. With that in mind, you can hedge the foreign exchange risk through a currency swap forward contract.
What are Derivative Instruments?
Derivative instruments are financial instruments whose value is based on an underlying security, such as a currency, physical commodity, or stock index. Both traded and over-the-counter derivatives are used to manage risk and to speculate.
Since derivative instruments are traded on an exchange, they do not directly impact its balance sheet. But because they are financial assets, they affect the company's income statement and liquidity.
Derivative instruments are financial assets, so they impact the income statement and the balance sheet. When a corporation launches a foreign exchange position, it will be exposed to foreign exchange rate movements that may cause gains and losses.
Hedging Forward Contracts
A forward contract is a financial contract that binds counterparties to exchange a certain asset at a designated time in the future. Forward contracts are used for hedging purposes in order to simplify the hedging process since the transaction is already pre-established.
In other words, the exporter will fix the price of the currency to be received in the future, while the importer would fix the price of the currency to be paid in the future. When the transaction is completed, the companies will exchange the currencies.
Example of a Swap Forward Contract
Let's assume that a company that produces its products in Europe contracts with a company based in the United States for the purchase of $3 million worth of computer equipment. In connection with the purchase, the U.S. company agrees to pay the European company $6 million. Their arrangement will be settled in Euro, at the prevailing exchange rate.
When is the Best Time to Use Forward Contracts for Managing FX Risks?
When There are Contractual Exposures and Forecast Cash Flows
Exposure occurs when a company is likely to be exposed to foreign exchange rate changes with no direct control over the exchange rate. But a forward contract can be used to reduce the risk from exposure.
The company can choose to buy a forward contract from a bank, the forward market, or another company. The forward contract would specify the amount of currency to be delivered, the exchange rate, and the delivery date for the currency.
Forecast Cash Flows
Some companies have forecast cash flows, which are cash inflows and outflows that are expected to occur in a future period. A company may use a forward contract if its future cash flows are highly variable but fairly certain.
For example, a company that exports its products would need to hedge against fluctuating foreign exchange rates. In this case, a company can use forward contracts to minimize its exposure to foreign exchange rates.
Long Duration Hedges
Hedges that are entered into for less than one year are called short-duration hedges. They are used to minimize the risk of price changes in a company's assets and liabilities in its foreign exchange position.
Since the forward contract is based on foreign exchange rates, a long-duration hedge provides insurance protection against large changes in the exchange rate. It does not matter if a company hedges its assets or liabilities.
A company can also use a combination of short-duration and long-duration hedges. This kind of strategy is referred to as a mixed hedge, and it usually minimizes the risk from its foreign exchange position. Most companies will use forward contracts to manage foreign exchange risk, especially if the company is exposed.
Currencies with Low-Interest Rate Differentials
If there is no interest rate differential between the currencies involved in a forward contract, the contract is referred to as a currency forward. Currency forward contracts are the most common type of forwarding contract since they allow counterparties to fix the exchange rate based on their expectations.
The parties to a currency forward contract are allowed to trade the currencies on either a spot or forward market at the prevailing exchange rate. The currency forward contract will also specify the currency to be delivered, the date of delivery, and the exchange rate for the delivery.
Measuring FX Risks Using Futures Contract
A futures contract is a financial contract that binds the buyer and seller to the delivery of a specific asset at a specified time in the future. Futures contracts are used for hedging purposes to simplify the hedging process since the transaction is already pre-established.
Since futures contracts are derivatives, the changes in the exchange rate will result in a gain or loss for a company that uses the contract for hedging purposes. The futures contract is based on the underlying asset in a foreign exchange contract.
Example of a Futures Contract
Let’s assume that ABC Company is doing business with XYZ Company in India. In connection with the transaction, ABC Company agreed to buy products from XYZ Company at a cost of $10,000.
The contract calls for an exchange of currency to be delivered in six months, based on the exchange rate at the time of delivery. The transaction will be settled in US dollars at the prevailing exchange rate.
Difference Between Futures and Forward Contracts
The terms of a forward contract and a futures contract are quite similar. In a forward contract, the exporter would agree to sell the foreign currency at some future date. Therefore, a forward contract is also referred to as a foreign exchange forward contract.
On the other hand, the terms of a futures contract are simpler than a forward contract. The exporter would agree to deliver the foreign currency by a certain date rather than sell it. Therefore, a futures contract is also referred to as a foreign exchange futures contract.
Since both the futures and the forward contracts are types of financial instruments, they allow the parties to trade the currencies at the prevailing exchange rate.
Measuring FX Risks Using Software as a Service (SaaS) Systems
The complexity of foreign exchange risk management and its role in the business world has made it necessary for banks and corporations to use reliable, robust software to manage their foreign exchange risks.
Effectively managing FX risks requires a good understanding of the foreign exchange market and the systems used by banks and corporations. Foreign exchange risk management software is used to manage these risks. The software can be either a standalone system or a service available over the Internet (SaaS).
Reval, Fincad, FiREapps, and More
These systems are designed to provide instant access to up-to-date information about foreign exchange risk, market data, and benchmarks so that you can take the appropriate action to manage your risk.
The software is also designed to provide detailed reporting and granular analysis of the risk positions, with a focus on all the financial and economic aspects of foreign exchange risk management.
The analysis is presented in an easy way for the finance department to understand. It allows the business to formulate strategies based upon the different types of risks that the company faces.
The Bottom Line: The Importance of Developing a Streamlined Foreign Exchange Risk Management Strategy
Foreign exchange risk management is a highly complex process. This is because the foreign exchange market is in constant flux, with volatile exchange rates and unpredictable market trends.
Foreign exchange risk management is a complex process that requires a comprehensive approach. It is also essential for companies to use an effective foreign exchange risk management strategy to manage their risks by hedging and managing their counterparty risk.
The financial industry’s presence is fast becoming felt in all sectors of the economy. Financial risk management is now of interest to the financial sector and a wide range of stakeholders in the community.
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!