Foreign Exchange Risk Management

Forex

The first question is whether it is even worth attempting to limit the risk. It's possible that a company views currency fluctuations as a cost of doing business and is prepared to deal with the resulting profit volatility. The company may have sufficiently high profit margins to protect against exchange rate volatility, or they may have such a strong brand/competitive position that they may boost prices to compensate for negative swings. Furthermore, the corporation may be trading with a country whose currency is pegged to the US dollar, however the number of countries with a formal peg is tiny and not particularly significant in terms of trade volume (with the exception of Saudi Arabia, which has a legal peg).

The techniques available to organisations that want to actively minimise foreign exchange risk range from simple and low cost to more complicated and expensive.

Transact in Your Own Currency

Companies with a strong competitive position and a strong brand may be able to deal in only one currency. Even when operating abroad, a US corporation may be allowed to insist on invoicing and payment in USD. This shifts the risk of currency exchange on the local client or supplier.

In fact, this may be challenging because certain expenditures, such as taxes and salaries, must be paid in local currency, but it may be achievable for a company that conducts most of its business online.

Protect your commercial relationships and contracts.

Many enterprises in the oil and gas, energy, and mining industries are subject to long-term contracts that may include a considerable foreign currency component. These contracts might run for years, and the currency rates at the time of agreement and price fixing may fluctuate, jeopardising profitability. It might be conceivable to include foreign exchange clauses in the contract that allow revenue to be recovered if exchange rates differ by more than a predetermined amount. Any foreign exchange risk is therefore passed on to the customer/supplier, and will need to be negotiated just like any other contract issue.

These can be a very successful way of protecting against foreign exchange volatility in my experience, but they do require strong legal wording in the contract and very explicit disclosure of the indexes against which the exchange rates are assessed. These provisions also demand that the finance and commercial teams conduct regular reviews to ensure that when an exchange rate clause is triggered, the necessary steps to recuperate the loss are taken.

Finally, if these clauses are activated, they can lead to difficult commercial discussions with clients, and I've seen organisations choose not to enforce to protect a client relationship, especially if the timing overlaps with the start of contract negotiations.

 Natural Foreign Exchange Hedging

A natural foreign exchange hedge happens when a company's revenues and costs are matched in foreign currencies, reducing or eliminating net risk. For example, a US corporation operating in Europe and earning Euros would attempt to source product from Europe for distribution into its home US business in order to put those Euros to good use. This is an example that simplifies the supply chain of most firms, but I've seen it work well when a company has locations in multiple countries.

However, it adds to the workload of the finance team and the CFO because tracking net exposures necessitates a multi-currency P&L and balance sheet.

Financial Instruments Hedging Arrangements

Hedging foreign currency risk with financial instruments is the most sophisticated, albeit presumably well-known, method of doing so. A forward contract or a currency option are the two most common ways to hedge.

1.Forward exchange contracts.  A forward exchange contract is a contract in which a company commits to buy or sell a particular quantity of foreign currency at a future date. The firm can protect itself from future variations in the exchange rate of a foreign currency by signing into this contract with a third party (usually a bank or other financial institution).

This contract's purpose is to hedge a foreign exchange position in order to prevent a loss on a certain transaction. In the previous example of an equipment transaction, the corporation can buy a foreign currency hedge that locks in the €/$ rate of 1.1 at the time of sale. A third-party transaction charge and an adjustment to reflect the interest rate gap between the two currencies are included in the hedge cost. Hedging can be done for up to a year in advance, while some of the major currency pairs can be hedged for longer periods of time.

Forward contracts have shown to be quite efficient in my career, but only if the organisation has good working capital practises in place. The protection's advantages are only realised if transactions (customer receipts or supplier payments) occur on time. To ensure this, strong coordination between the Treasury function and the cash collection/accounts payable teams is required.

2.Currency options. Currency options provide the corporation the option to buy or sell a currency at a specified rate on or before a specific date, but without the responsibility to do so. They are similar to forward contracts in that the corporation is not obligated to perform the transaction after the contract expires. As a result, if the exchange rate of the option is better than the current spot market rate, the investor will exercise the option and profit from the contract. If the spot market rate was lower, the investor would let the option expire worthless and trade in the spot market. The corporation will have to pay an option premium to gain this flexibility. Let's say the corporation wants to take up an option instead of a forward contract for the equipment, and the option price is $5,000.

In the event that the USD falls from €/$ 1.1 to 1.2, the corporation would exercise the option and prevent a $10,000 exchange loss (albeit the option cost would remain $5,000).

The corporation would let the option expire and bank the exchange gain of $15,000, leaving a net gain of $10,000 after accounting for the option's cost. In actuality, the cost of the option premium will be determined by the currencies traded and the duration of the option. Many businesses believe the expense is too high.