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.
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.
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.
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.
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.
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.
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.
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
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.