Foreign Exchange

A Guide to FX Risk Management Tools

Just about every company that has conducted business outside its home country has experienced the pain of losing money due to fluctuations in currency exchange rates. These losses don't just happen at the moment of cash conversion. There's also an economic cost of forecasted transactions, which is when exchange rates move during the time elapsed between the forecast and the purchase or sale of product. In addition, companies may experience losses due to foreign currency translation adjustments. These stem from line items on the balance sheet or income statement. Finally, a company may experience an opportunity cost if they choose against pricing in the local currency when buying or selling goods in another country. While company managers may think think they are avoiding currency risk by pricing in their home country currency instead of a local currency, in reality this places them at a competitive disadvantage, and comes with an inherent risk premium that benefits the other party in the transaction. 

Plan Ahead to Manage Risk

Companies of all sizes need a plan that includes identifying and quantifying the foreign currency risk, determining organizational risk tolerances, writing policies and procedures for foreign exchange, execution parameters and counterparty relationships, establishing effective reporting and accounting practices, and ongoing reevaluation and assessment. 

 Companies need an executable plan to identify, quantify and manage their foreign currency risk.

Companies need an executable plan to identify, quantify and manage their foreign currency risk.

What Tools Are Involved?

A word of warning: company managers might be tempted jump the gun and move right into questions of execution parameters. They can be quick to ask, “What tools should we use to mitigate the risk?” without first building a comprehensive risk management plan. But without a holistic plan in place, foreign currency management tools will only take a company so far, no matter the tools' level of sophistication. That being said, once managers effectively build a comprehensive strategy, they will find a variety of good tools at their disposal to execute their plan. Small to mid-sized companies in particular may use the following tools to control currency exposure.

Natural hedging

In this context, a natural hedge is a method of reducing foreign exchange risk—for example, the risk of losing money due to movements in the currency exchange rate—by offsetting revenue generated with costs incurred in the same currency. While natural hedging is seldom a perfect solution, it does not require the use of sophisticated financial products such as derivatives. For a practical look at natural hedging, see our article entitled, A Non-Hedging FX Risk Management Strategy.

Spot exchange

A spot exchange rate is the price to exchange one currency for another for immediate delivery. The spot rates represent the prices buyers pay in one currency to purchase a second currency. Although the spot exchange rate is for delivery on the earliest value date, the standard settlement date for most spot transactions is two business days after the transaction date. The most common exception to the rule is the U.S. dollar vs. the Canadian dollar, which settles on the next business day. Weekends and holidays mean that "two business days" is often far more than two calendar days, especially during the Christmas and Easter holiday season. For more information on the spot rate of exchange, see ISDA Definitions at ISDA.org.

On the transaction date, the two parties to the transaction agree on the price, which is the number of units of currency A that will be exchanged for currency B. The parties also agree on the value of the transaction in both currencies and the settlement date. If both currencies are to be delivered, the parties also exchange bank information. Speculators often buy and sell multiple times for the same settlement date, in which case the transactions are netted and only the gain or loss is settled.

Swap Contract

A swap is a derivative contract through which two parties exchange cash flows based on some notional amount and an “underlying.” The underlying can be almost anything. Currency swaps involve cash flows based on a notional principal amount and a currency pair that both parties agree to in the swap contract.

Swaps are generally not exchange-traded instruments, unlike most standardized options and futures contracts. Instead, swaps are customized contracts that are traded in the over-the-counter (OTC) market between private parties. Firms and financial institutions dominate the swaps market, with few (if any) individuals ever participating. Because swaps occur on the OTC market, there is always the risk of a counterparty defaulting on the swap. To read more about swap agreements, see An Introduction To Swaps on Investopedia.

Option Contract

The owner of a currency option has the right, but not the obligation, to exchange a specified amount of one currency for another currency at an agreed-upon rate of exchange. In the OTC market for currency options, for example, one party may purchase an option to exchange an amount of currency A for a specified amount of currency B. The purchaser of the option then has the right, but not the obligation, to make the exchange at the specified time in the future.

The key benefit of the option contract is that exercise is entirely at the owner’s discretion. At the time of exercise, the owner may elect the most favorable of the spot exchange rate and the exchange rate specified in the option contract. The option premium is usually paid upfront, reflecting the value of this beneficial asymmetry.

There are numerous types of options (e.g. European, American, Burmudan, to name the most popular) that differ in the terms of exercise (what the contract states about when the owner may settle the specified transaction). For more information on the spot rate of exchange, see ISDA Definitions at ISDA.org.

Forward Contract

A currency forward contract is an agreement to exchange a set amount of one currency for another at at a specified price for settlement a predetermined time in the future. There are several types of currency forward contracts that differ in the terms of settlement. A Deliverable Forward requires the actual currency to be exchanged at settlement. A Non-Deliverable Forward allows the contract to be settled without exchanging currency. The “net settlement” is calculated based on the difference between the prevailing spot exchange rate and the exchange rate specified in the contract. A Window Forward allows the settlement over a period (window) of time rather than one specific date, allowing more flexibility. For more information on the spot rate of exchange, see ISDA Definitions at ISDA.org

Which is best?

So which tool is the best to use? Well, the answer depends on the company’s objectives and constraints and which instrument (or combination of instruments) will satisfy its objectives and constraints most optimally.

ABC Distribution Case Study

Let’s consider a company with thin profit margins and short periods of exposure throughout the year. Management has determined that its revenue in Europe must come with an average exchange rate of 1.06 U.S. dollars per one Euro. A lower exchange rate is unacceptable, but the company must capture some upside if the exchange rate goes higher. The company has ample cash on hand. In this simple scenario, a series of option contracts seem to be the appropriate choice. A purchased option requires upfront payment of a premium, but preserves the upside potential given a rise in the rate of exchange (EURUSD). It also ensures that the company’s effective exchange rate stays above a certain level (a floor). Over-the-counter (OTC) options can start and end at any time in the future, depending on the company’s forecasted cash flow.

XYZ Manufacturing Case Study

Another situation is XYZ, a manufacturer of goods with a six-month production cycle and relatively high profit margins. With this long lead-time, the company has good visibility into the future, but long periods of currency exposure once the purchase orders have been placed. Past earnings volatility have led XYZ’s stakeholders to question management’s understanding of the business, even though management’s volume and pricing forecasts have been accurate (the timing and magnitude of currency exchange rates has caused the volatility). Finally, XYZ’s working capital is in high demand, with no excess cash available. In XYZ’s case, a series of forward contracts seems most practical.

For a more in-depth look at a case study, see Grayline’s article entitled, Effective FX Risk Management Strategy, a case study of currency risk in Brazilian telecom equipment manufacturer.

More Questions…

In this article, we’ve addressed questions of specific instruments available to companies wishing to control the negative impact of currency movements on earnings and performance. While it is crucial to understand the tactical alternatives available to manage currency exposure, these instruments must be utilized responsibly within a solid framework for currency risk management, including these key elements:

  • Established Organizational Risk Tolerances
  • Corporate Polices and Procedures for Approaching FX Risk
  • Identification and Quantification of Currency Risk
  • Approved Execution Parameters and Counterparty Relationships
  • Accepted Reporting and Accounting Practices
  • Regular (periodic) Evaluation and Assessment of FX Risk Management 

Interested in more insights into Currency Risk Management? Refer to http://graylinepartners.com/insights and contact us at info@graylinepartners.com

About Grayline Partners

Specialists in risk management, regulatory compliance and business analytics, Grayline Partners and its founder Mark Henderson have more than 25 years of experience in helping companies manage a wide range of different types of business risk, including currency exchange risk.

 

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Effective FX Risk Management Strategy

Effective FX Risk Management Strategy

A Brazilian telecomm equipment manufacturer struggled with its exposure to the changing currency exchange rates. An assessment revealed that the volatility affected its revenue by 22% and its net income by even more. 

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The Impact of BREXIT on U.S. Corporations

The Impact of BREXIT on U.S. Corporations

Insight on the recent impact of Britain's exit from the EU.

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A Non-Hedging FX Risk Management Strategy

Exporters can avoid foreign exchange exposure by using the simplest non-hedging technique: Price the sale in a foreign currency, and then demand cash in advance. The current spot market rate will determine the U.S. dollar value of the foreign proceeds. A spot transaction is when the exporter and the importer agree to pay using today’s exchange rate and are willing to settle within two business days.

Another non-hedging technique is to net out foreign currency receipts with foreign currency expenditures. For example, the U.S. exporter who exports in pesos to a buyer in Mexico may want to purchase supplies in pesos from a different Mexican trading partner. If the company’s export and import transactions with Mexico are comparable in value, pesos are rarely converted into dollars, and FX risk is minimized. The risk is further reduced if those peso-denominated export and import transactions are conducted on a regular basis.


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A Solid Approach to Currency Risk: A Primer

Foreign exchange is a risk factor that is often overlooked by small and medium-sized enterprises (“SMEs”) that wish to enter, grow, and succeed in the global marketplace. Although most U.S. SME exporters prefer to sell in U.S. dollars, creditworthy foreign buyers are increasingly demanding to pay in their local currencies. For a U.S. exporter who chooses to sell in foreign currencies, FX risk is the exposure to potential financial losses due to devaluation of the foreign currency against the U.S. dollar.

Grayline-Partners_Currency-Risk

Companies can avoid this exposure by insisting on sales in U.S. dollars. However, that approach may result in losing export opportunities to competitors who are willing to accommodate their foreign buyers by selling in their local currencies. It could also result in the non-payment by a foreign buyer who may find it impossible to meet U.S. dollar-denominated payment obligations due to the devaluation of the local currency against the U.S. dollar. While coverage for non-payment could be covered by export credit insurance, such “what-if” protection is meaningless if export opportunities are lost in the first place because of the “payment in U.S. dollars only” policy.

But when foreign exchange risk is successfully managed, selling (or buying) in foreign currencies can be a profitable alternative for U.S. exporters. And here’s what you need to know:

  • Most foreign buyers generally prefer to trade in their local currencies to avoid exposure to changing currency rates of exchange.
  • U.S. SME exporters who choose to trade in foreign currencies can minimize foreign exchange exposure by using straightforward risk management techniques available in the United States.
  • The volatile nature of the currency markets poses a great risk of sudden and drastic currency movements, which may cause damaging financial losses against otherwise profitable export sales.
  • Solid currency risk management minimizes potential currency losses (not to make a profit from currency movements, which are often sudden and unpredictable).

Since business activities across borders often expose a company to changing currency exchange rates, exposure can be both transparent and non-transparent. That’s why Grayline’s risk analysis process is comprised of the following five step process:

  1. FX Risk Identification

    Understand a business requires uncovering FX risks embedded in tax strategies, supply chain, and product delivery channels. (The impact is often hidden, affecting earnings, cash flows, and balance sheet composition.)
     
  2. FX Exposure Analysis

    Quantify earnings and cash flow at risk due to changes in currency exchange rates weekly, monthly, quarterly, annually. Measure the uncertainty and opportunity cost of over-hedging or under-hedging.
     
  3. Hedge Recommendations/Presentations

    Recommend potential hedging strategies and simplify needless complexity. Compare the various degrees of impact on income, cash flow, and balance sheet.
     
  4. Hedge Execution

    Address the regulatory, governance, credit, accounting, and educational requirements of each recommendation and create a plan to execute.
     
  5. Valuation, Monitoring, and Analysis

    Value the hedge (and the hedged item, if necessary), provide accounting advice and/or journal entries, and set up a framework for monitoring the effectiveness of the program.

Determine the aspects of your company’s approach that makes it solid, and identify the biggest challenges.

To learn more about how Grayline can help your business manage currency risk, contact us.


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The Real Winners in China’s Upheaval

In her August 2015 Wall Street Journal article “China Economic Upheaval Mints Winners and Losers,” author Laurie Burkitt fails to mention one key winner: Those companies that outsource elements of their supply chain to China. They win because currency exchange rates continue to favor savvy USD buyers.

The statistics about China’s recent explosive economic boom — and subsequent slowdown of growth — were both helpful and eye-opening. That is, many knew China’s economic growth was strong, but many may not have realized exactly how strong.

Throughout the last decade infrastructure companies from all over the world rushed to meet China’s demand which helped spur further growth, peaking in 2011. Since then double-digit growth continued but the numbers have inevitably shrunk.

Grayline-Partners_China-FX-Risk

The Back-Story to China’s Growth

What makes this topic timely is the huge volatility in China’s stock market, which has several proximal causes. While the economic statistics sited in the article aren’t new (they have been closely tracked through the last eighteen months), in retrospect, China’s stock market bubble should have been obvious. But the huge economic declines have been a big surprise and a cause for legitimate concern. What does it mean? Not just for US companies working on infrastructure projects in China, but for the developing economics of the Chinese people. Will they, like the article suggests, continue to be largely unaffected? Personally, I doubt it.

Historically, the stock market is not an isolated factor and, unlike consumer sentiment, it is a leading indicator. The article sounded a lot like the articles written in the wake of the 1987 crash. Those interviewed didn’t feel any different than the week before the sell-off, which is understandable.

Today, consumers continue to spend and the retail sector is strong. That’s exactly what people said in 1987. The reasoning was something like, “Stocks are not as widely owned as they were before the 1929 crash and the subsequent Great Depression.” But that didn’t seem to matter then because the drop in the stock market was a signal of a severe economic pullback that, one way or another, affected every single person. I suggest that the same is true in the case of China’s upheaval.

So, who are the real winners?

As noted previously, the real winners were omitted from Burkitt’s article: Savvy US companies doing business with China’s suppliers. Not every company working with China in its supply chain, however, will benefit, because the determining factor is currency exposure.

Companies purchasing China-made products and services in USD have “managed” currency risk by passing it along to their Chinese suppliers. In that case, the suppliers will be beneficiaries of any weakening in their currency. Those suppliers will convert revenue received in dollars to more yuan than last year, with more profit left over after paying employees in yuan. In contrast, companies that negotiated lower prices because they retained currency exposure instead of passing it along may be poised to benefit from the strengthening dollar.

Managing Currency Risk

The key take-away is not whether a company chooses to bet on currency exchange rates. Instead, the important questions are:

  • What is my firm’s currency exposure?
  • How do we measure (quantify) it and what is my company’s tolerance?
  • What is the best way to manage it?
  • How do we communicate this to our board and other stakeholders?

By spending time to research and answer these questions, an organization can develop a consistent framework for managing its currency risk.

While there are multiple approaches that can be used to achieve this goal, Grayline’s Six-Factor Framework has been successfully deployed with a number of businesses to help them manage currency risk.


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