Policies & Procedures

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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Measuring Risk to Hedge CVAs

The market volatility experienced during the 2008 financial crisis has driven many firms to review their methods of accounting for counterparty credit risk.

The traditional approach of controlling counterparty credit risk has been to set limits against future exposures and verify potential trades against these limits. Credit Value Adjustment (CVA) offers an opportunity for banks to move beyond the control mindset of limits by dynamically pricing counterparty credit risk directly into new trades.

Many banks already measure CVA in their accounting statements, but the financial crisis has led pioneering banks to invest in systems that more accurately assess CVA, and integrate CVA into pre-deal pricing and structuring. Their expected return on investment is the ability to support future growth by freeing up more capital and minimizing earnings volatility.

But how do you quantify these risks? How, for example, do you measure reputation risk?

In Douglas W. Hubbard’s book, "How to Measure Anything," he defines risks like these and lays out helpful ways to think about quantification. Without that, trying to manage these risks is impractical at best. At worst, it’s a foolish waste of time that does no more than check a box.

Beyond the Box

Arguably, going “outside the box” may not be required in order to employ leading practices in the realm of risk management and regulatory compliance. It is almost certain, however, that managers move beyond the mentality of simply “checking the box.” That is, merely doing anything just to “get it done” will leave the company in an undesirable state. At the very least, managers and employees will be without direction; more than likely, they will go astray and incur even risk without benefit.

Using a proprietary assessment tool, Grayline helps companies evaluate and rank the state of their internal risk measurement and reporting. Contact us today for a complimentary assessment.

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How Smart Companies Prepare for Rising Rates

With every anticipated interest rate adjustment, we notice an increase of jitters among our clients. If the Fed raises interest rates, will that put a drag on GDP growth or even crush it altogether? They could opt to wait, but such a holding pattern seems unlikely as it could lead to inflation with easy money and “runaway” expansion.

In one article, "What to Expect as the Federal Reserve Decision Nears," author Jeffrey Moore asks the burning question: which way will the Fed lean in order to do the “wrong” thing?

The implications for global business are huge. An increased demand for the greenback will widen the already appreciable gap between the USD and other currencies. As other currencies continue to weaken, this will threaten the earnings of domestic companies generating business abroad.

But before the dust settles, smart companies must decide how to position themselves for rising rates. It’s a matter of when, not if.

How Smart Managers and Board Members Respond to a Potential Interest Rate Hike

“Smart” companies—no matter what size—are doing at least three things to prepare. They always have, to varying degrees. But now they’re doing them with stepped-up urgency and energy:

  • Evaluate their company’s debt service and capital structure
  • Optimize capital structure around goals and limits
  • Take action early

Smart companies also respond to events in the economy by continually reevaluating their position in light of new information. They ask key questions early — and often.

  • How is my company servicing its debt today?
  • What portion is fixed or floating?
  • Will that change if we do nothing? Are there covenants that may take effect under certain conditions? Will those conditions get triggered in a rising rate environment?
  • What about my company’s debt/equity mix?
  • Have I considered financial instruments that may improve the capital structure?

And smart companies don’t wait until all of the uncertainty is taken out of the equation (that is, after rates rise or after the dollar strengthens or weakens). They know that by then, it’s too late. Instead, they assess their current position, determine the optimal positioning, and act early. Smart companies build risk management into their operations, and the process of assessing, optimizing, and acting is ingrained in the company’s DNA.

The Benefits of a Good Assessment

After assessing its strengths and vulnerabilities, a company must determine the optimal positioning to benefit from (or avoid the downside of) potential events. If the economic context never changed, companies would never need to adjust their balance sheets or capital structure. It is precisely because economic conditions are uncertain–and constantly in flux–that smart companies position themselves to benefit optimally.

Nobody knows exactly what will happen, but every company can be prepared for changes in the economy whether or not they’ve forecast correctly.

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