Effective FX Risk Management Strategy

Currency Risk in Brazilian Telecom Equipment Manufacturer: A Case Study

A US parent (functional currency USD) sources from a Brazilian subsidiary in Brazil, and distributes in the US, Canada, Japan, and Europe. Gaps in the hedging process revealed FX exposure equal to 30% of the parent company’s revenue.

The company was surprised to discover that their existing hedge program was capturing only 50% of the parent’s exposure. The recommended program combined forward rate agreements in relative proportion with appropriate accounting and transaction timing to substantially reduce the parent’s exposure.

Key Insight: Identify and Quantify Exposure

In this particular case, the company did not understand the full extent of its exposure to currency exchange rates. From one perspective, they did understand the extent of the exposure and were able to quantify it. However, they were systematically missing at least 70% of the overall exposure. There were several reasons for this:

  • Too little communication along the supply chain
  • Lack of financial visibility (non-transparent risk)
  • Insufficient analysis (business analytics)

But these challenges are not unique to this company. More than 80% of companies we encounter are in the same situation, and when we discover these aspects several questions arise. What do these mean? What are the consequences? How would our company function if these elements were addressed?

Each of these answers comes with its own story, and the story begins with the life of the company’s product delivery.

The Supply Chain: A Closer Look

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In this simplified workflow, the customer places the order in a foreign currency (a currency other than the company’s functional currency). At the time the customer receives an invoice, the amount is reflected as accounts receivable on the company’s balance sheet.

As an asset denominated in another currency, it must be translated into the company’s reporting currency on each reporting date until the receivable is collected. The foreign currency translation adjustment (FCTA) is the change in the translated amount from the last reporting period.

Knowing this, the company’s finance department hedges the amount of currency it expects to receive to the date the receivable is due. The changes in the FCTA line item on the income statement are offset by changes in the market value of the associated hedge. The result is that the company no longer experiences the unpredictable volatility in net income due to fluctuations in currency rates of exchange.

In this case, the invoice amount was BRL 250,000. On the date of the invoice, the exchange rate was 0.3351 (USD 0.3351 per 1 BRL). The amount, therefore, of revenue was recorded as USD 83,775.

When the invoice was sent to the customer, it became a BRL 250,000 receivable. At the end of the period (November), the receivable was translated into USD using the spot rate at the end of November (USD 0.3351 per 1 BRL). Since the receivable was not collected until January of the following year, the receivable was translated again from BRL to USD for December period-end reporting. The exchange rate at the end of December was USD 0.3240 per 1 BRL.

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Speaking only of this single transaction, the effect of the fluctuations in the currency exchange rate in that period turned out to be  USD 22,500 and there are two statements to make about that phenomenon: 

  • First, while the effect was small, it was entirely avoidable. With an ongoing process of hedging receivables, the net income effect of all currency fluctuations can be neutralized.
  • Second, the effect could have been large had the fluctuations been larger. The annualized volatility of the BRL (taken over the period of a month) is over 11%. That means the change is likely to be greater over an extended period of time.

What’s the Problem?

If all of this was already happening and net income was insulated from fluctuations in currency exchange rates, what’s the problem? Where is the remaining currency exposure?

In this example, it took 3 - 6 months from order to delivery (depending on the size of the order and the backlog). Since the customer places an order in a foreign currency, the company is exposed to changes in the rate of exchange between its functional currency and the foreign currency in the amount of the order. Because of the volatility of the Brazilian Real versus the US Dollar during the period, the company lost 17% of the revenue associated with this order:

  • From the time the customer placed the order to the time the order was fulfilled, the BRL to USD exchange rate went from 0.4288 to 0.3351 (USD per 1 BRL), representing a 22% decline in value.
  • When the customer placed the order for BRL 250,000 in June, the order was worth $107,200 (BRL 250,000 x 0.4288).
  • When the order was fulfilled in November, the invoiced BRL 250,000 was worth only $83,775 (BRL 250,000 x 0.3351).

Without a framework for communicating the importance of timing and magnitude of orders, deliveries, and billing, the company experienced significant exposure, and in this case, substantial loss that could have been avoided.

In that year, the portion of the company’s annual revenue in Brazil was BRL 15 million. Every order did not experience the same magnitude of exposure, but the currency volatility caused the company's Brazilian business to earn 25% fewer US dollars than expected. 

Non-Transparent Risk: Lack of Financial Visibility

There's no doubt that the communication along the supply chain could have given the company more warning about the potential currency exposure. However, even with advance notice, the exposure may not have been visible to the risk managers. That’s because the currency exposure from the three to six months prior to the fulfillment of the order was not captured by any of the company’s financial reports.

This lack of visibility was not a flaw with financial reporting. To the contrary, the company’s books were kept accurately in both US GAAP and Brazilian GAAP. The issue is that GAAP accounting does not reflect future revenue, even with the contracts in place. Despite the company’s confidence in its forecasts and the reality of future revenue, the company’s future revenue was recorded when it was booked and the principle of matching revenue and costs.

Managing non-transparent risk (as opposed to the risk which is more visible because it is recognized in net income) requires an understanding of the company’s supply chain from manufacturing, to delivery and billing. It also requires a thorough understanding of the capital markets and hedging. Only with knowledge of these two domains together is it possible to manage risk holistically.

Knowledge is Not Enough

But a deep understanding of the company’s supply chain and knowledge of the capital markets and hedging is not enough. These domains of expertise must be applied. Companies like the one in this case study must employ targeted business analytics to shine the light on the drivers of risk. The drivers go beyond currency rates to the timing and magnitude of cash flows, contracts, trading relationships, reporting, accounting, and process.

After a company establishes, implements, and begins to use a sound business analytics approach, it can begin asking and answering the questions that will lead to sound risk management practice.

Contact us to learn more about how Grayline tackles risk management.

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