A recent article in Directors and Boards Magazine highlights the need for stakeholders to ask questions about currency risk. While the direction and strength of the U. S. dollar is seldom a sure thing, you can bet that currency exchange rates (sometimes called "foreign exchange rates" or "FX") will continue to be volatile.
Corporations face a wide range of different kinds of risk today. Cybersecurity, fraud and business interruption due to a disaster (whether natural or man-made) are just a few that keep many CEOs awake at night.
But there’s another risk faced by companies conducting business internationally that tends to fly under the radar: currency exchange risk.
Also known as foreign exchange or FX risk, this type of risk exists when a financial transaction is determined in a currency other than that of the base currency in which a company operates. An estimated 80 percent of mid-sized U.S. businesses export or import products, services or supplies, and these businesses must deal with FX risk one way or the other — even if they don’t realize it.
FX Risk Can Impact Profit
When negotiating a financial contract, U.S. companies that do business with overseas customers and vendors can designate payments in either U.S. dollars or the base currency of the country in which their customer or vendor is located. If payments are denominated in a currency other than U.S. dollars, the U.S.-based company will face currency exchange risk due to the daily fluctuations in currency exchange rates.
These fluctuations can have a significant impact on a company’s revenue, expenses and bottom line. For example, a 10 percent move in currency value can wipe out 50 percent of a company’s earnings due to lower-than-expected sales revenue or higher-than-expected raw material or inventory costs.
Currency exchange risk isn’t new — it has been around for as long as businesses in different countries have conducted international trade. But it is now more pronounced due to the interconnectedness of businesses all over the world and the volatility of the global economy and marketplace. Today, almost every business is affected either directly or indirectly by global events, whether it’s a neighborhood mom-and-pop laundry service or a billion- dollar multinational corporation.
The good news is that currency exchange risk can be identified, quantified and managed within a systematic framework.
The goal, in FX risk management, isn’t to predict in which direction currency exchange rates will move — or in other words, to speculate on foreign currency exchange. Instead, FX risk management is designed to ensure a certain level of financial performance regardless of exchange rate fluctuations.
Many large international corporations have entire departments devoted to managing currency exchange risk, but most small and mid-sized businesses don’t have the resources to devote to this full-time. The challenging accounting, tax, regulatory, analytical, and capital markets domains relating to currency exchange risk require sophisticated expertise that most small and mid-sized companies simply do not possess.
Managing FX risk effectively requires in- depth experience and expertise in foreign currency exchange, which isn’t a core competency for most firms. That’s why it usually makes sense for smaller and mid- sized firms to outsource currency exchange risk to a competent and trustworthy third party that specializes in this, while establishing clear lines of accountability and reporting.
Two FX Risk Management Scenarios Reveal Real-time Vulnerability
There are two main scenarios in which small and mid-sized firms could benefit by taking steps to manage their currency exchange risk:
1. A one-time overseas event:
In this scenario, a particular event occurring overseas presents a company with FX risk. A good example is the construction of a new building or manufacturing plant, in an overseas country. Since this is a long-term project, the currency exchange rate could fluctuate considerably between the start and completion dates of the project, which will impact the final cost. In general, the longer the timeframe of the event, the greater the potential currency exchange risk.
2. An ongoing overseas customer or supplier:
Here, a domestic company does business on a regular basis with a customer or supplier located overseas. If payment is denominated in the overseas customer’s or supplier’s currency, the domestic company will face FX risk each time a payment is received from a customer or made to a supplier.
In deciding whether or not to take steps to manage this FX risk, businesses must determine how significant the risk is to their organization. Companies differ in their definition of what is and isn’t “significant,” but anything that impacts earnings by more than 0.01 per share during a quarterly reporting period (or the equivalent for a non-public company) will be visible and thus likely to be considered significant.
FX Risk for Manufacturers
There is inherent currency exchange risk facing any U.S. manufacturer doing business overseas. As an example, ABC Manufacturing Corporation, located in Detroit, Mich., lands a big contract to manufacture customized heavy equipment for a new customer in Germany. The contract stipulates that payment to the company will be made in euros, not U.S. dollars. It will take ABC Manufacturing six months from the date the contract is signed to deliver the equipment. During this six-month window, the exchange rate between the euro and the U.S. dollar will fluctuate — perhaps considerably — and these fluctuations could work for or against the manufacturer.
If the value of the dollar declines against the euro, ABC Manufacturing will benefit and pocket more dollars when it converts euros to U.S. dollars. But if the value of the dollar rises against the euro, ABC Manufacturing will pocket fewer dollars when it converts euros to U.S. dollars.
Ultimately the manufacturer must make a decision: It can choose to “roll the dice,” so to speak, and hope that the exchange rate between the euro and the dollar moves in its favor over the next six months. If it does, the company will earn more revenue and profit. But if it does not, the company could see its entire profit vanish simply due to changing currency exchange rates.
Gambling in foreign currency exchange isn’t usually a risk that small or mid-sized businesses should be taking. Instead, a better strategy is to identify, quantify and manage FX risk than take the chance that currency fluctuations could wipe out the profits on overseas sales. The best way for most small and mid-sized companies to reduce or manage this risk, is to outsource currency exchange risk management to a trusted third-party that specializes in FX risk.
FX Risk for Service Businesses and Firms Importing Supplies
Manufacturing businesses are not the only companies facing potential currency exchange risk by contracting with companies overseas. Consulting and service based organizations also face FX risk. For example, a marketing company contracts with an overseas business to provide a monthly service. The overseas company stipulates the contract will be paid in Yen, the home currency of the overseas company based in Japan. Every month of the contract the U.S. based marketing firm risks potential loss due to currency exchange risk.
So how does FX risk affect domestic companies that purchase raw materials or inventory from overseas suppliers? Let’s look at ABC Manufacturing again, which purchases materials used in the manufacture of heavy equipment from a supplier located in China. Its contract with the supplier stipulates that payment will be made in Yuan, not U.S. dollars. Fluctuations in the exchange rate between the Chinese Yuan and the dollar will impact the price the manufacturer pays for these materials, which in turn will affect its costs and profitability. The company can protect its bottom line by taking steps to manage this currency exchange risk.
Different types of industries (like manufacturers, retailers and service businesses) experience currency exchange risks with varying characteristics. For example, the main FX risk exposure variables for manufacturers are the length of the production cycle, the players in the supply chain, the customers’ ability to place orders well in advance of delivery, and the relationships between supply, production and sales.
These variables will impact both the magnitude and timing of a manufacturer’s currency exchange risk exposure. The longer the production cycle, the greater the company’s FX risk exposure. So a manufacturer of customized heavy equipment, like the one in the example above, may experience more currency exchange risk than a manufacturer that sells commodity parts that can be produced and shipped within a week.
Direct vs. Indirect FX Risk
At this point, a fairly obvious question is: Why not just insist that overseas customers and vendors make payment in U.S. dollars instead of a foreign currency? Wouldn’t this shift the currency exchange risk to them?
The short answer is “yes,” but there are potential trade-offs that present an indirect FX risk to a domestic company. The biggest trade-off is that the overseas company will likely factor this risk into their cost and pricing decisions, so a domestic business may have to charge less for their products or services or pay more for materials and supplies. Another trade- off is that this could make a business less competitive if its competitors are willing to designate transactions in a foreign currency, which could result in lost sales and revenue.
The Challenges of Forecasted Transactions
Even companies that recognize and plan for FX risk mitigation sometimes fail to identify the largest contributor to currency exchange risk exposure: forecasted transactions. While some fluctuations in currency exchange rates show up on the income statement — such as translation of accounts receivable in a company’s non-functional currency — forecasted transactions do not.
The first step in managing this type of risk exposure is to identify which areas of the revenue cycle and supply chain expose a company to currency fluctuations. The next step is to quantify this risk, which can be a time-consuming process that involves more than just a cursory look at an Excel spreadsheet.
Often, derivatives are used to manage this type of FX risk. While capital markets desks at large banks are good at showing different derivative structures, the hard part is choosing the best derivatives for a company’s unique situation. The best structure will match each element of a company’s exposure, adjust for future cash flow visibility, avoid needless complexity and allow for consistency and benchmarking over time.
The Role of ERM: Is it Enough?
Risk management is integral to everything a company does, which is why some corporations have created a new role: the Chief Risk Officer, or CRO. A CRO is usually tasked with managing operational risk across the enterprise and may utilize Enterprise Risk Management (ERM) software to help accomplish this.
While ERM can help corporations identify and manage many different types of risk, it often misses the nuances of currency exchange risk. FX risk is typically given little more than a cursory nod within the context of a broad ERM framework, so it falls through the cracks. But this isn’t to say that ERM can’t be a valuable tool in managing currency exchange risk.
Cutting-edge international firms use the capabilities of their ERM software to support their FX risk management framework and centralize FX risk management. For example, ERM’s performance measurement capabilities and the data gathering that’s required, create better visibility into activities that can expose a company to currency exchange risk.
Keep in mind that decentralized management of currency exchange risk at the business unit level can be costly and merely provides a temporary fix. Conversely, centralizing FX risk management creates a systematic framework for currency exchange risk management that helps ensure buy-in and engagement across the entire organization.
With or without the help of ERM software, proactive and forward-looking international businesses are implementing an organization-wide framework for managing currency exchange risk. Such a framework takes a holistic approach to identifying, measuring and managing FX risk, as well as reporting this risk to the board of directors and other corporate stakeholders.
Currency exchange risk is real for any firm that conducts business internationally. As a result, CEOs, COOs and CROs must first quantify the level of FX risk exposure within their organization. Then, they must make a decision how to manage it — whether within a systematic FX risk management framework, or to absorb the risk internally.
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.