When a company is trading globally, there is always a foreign exchange risk involved. The forex market is perhaps one of the most active and volatile markets in the world with trillions of dollars changing hands in different currencies daily. When companies are exchanging goods and services worldwide, there are always associated financial risks that need to be either minimized or mitigated. At the same time, hedging currencies also offers potential financial gains for companies that manage their currency exchanges effectively.
To unfold how foreign exchange risks could be decreased, in the first part of our FX risk management article series, we will take a closer look at the challenges of managing multiple currencies. While it’s a complex task, it’s worth identifying how you could overcome some of these challenges and manage FX risk throughout the entire organization.
What is foreign exchange risk?
Foreign exchange risk (FX risk, exchange rate risk, or currency risk) is a type of risk that occurs when a financial transaction is executed in another currency than the domestic currency of the company. FX exposures can derive from both internal functions, but also from external sources. Internal forces that may result in foreign exchange risk can come for example from treasury, trading, or technology. However, external forces can be concerning too regarding foreign exchange. Such forces are, for example, currency volatility, government-imposed cash restrictions, or interest rate shifts can all have serious downsides. Transfer pricing exposures or unforeseen events in certain countries or even globally can also affect the currency risk a company carries.
The challenges of navigating FX risk
Navigating FX risk can be challenging for a variety of reasons and all of them should be considered to minimize the risk effectively. FX exposures often hide in plain sight on a company’s balance sheet, for example, whenever a company is actively managing its bank accounts in the countries it is operating, the intercompany transactions mean that there is a foreign currency risk exposure. Whenever a corporate is trading in multiple currencies, both internal and external forces that can result in FX risk should be considered and mitigated.
To be able to navigate the company’s FX risk challenges, the most important starting point is to understand the company’s cash flows, where cash is coming from, where it is going, and in which currencies. We could say so that it’s time to look under the hood: what is appearing on the balance sheet that could potentially be risky and what could be discovered by analyzing the incoming and outgoing cash flows. Having visibility into cash flows and the liquidity position of the company will be the starting point to hedge currencies.
Considering the main factors that could hinder a company’s potential to successfully manage and minimize foreign exchange currency risk, we have found that among other components, inaccurate forecasting and poor cash visibility, siloed data, and unforeseen global events and disruptions in the global supply chain can have the biggest negative impact on dealing with currency risk.
Inaccurate forecasting & poor cash visibility
Inaccurate forecasting and poor visibility into cash positions and future cash flows can have vastly negative effects on FX risk. This is one of the key findings in the ‘Global Treasury Survey 2021’ from PWC that was conducted with the participation of global CFOs. For example, US companies have been dealing with the US dollar becoming stronger against major currencies, and organizations should realize and address the related risks. To be able to do that, they do not only need to have insights into these exposures but gaining visibility of the company’s cash flows and positions can be also vital. In an earlier survey conducted by Deloitte in 2016 on the topic of global foreign exchange, 56% of treasurers have also agreed that the biggest challenge of managing FX risk is the complexity of FX forecasts and the lack of visibility.
Data is siloed
Naturally, you don’t start improving FX risk first without making sure that you manage your liquidity or you utilize predictive analytics to understand your future cash flows also in the long term.
When a company emphasizes liquidity management and cash flow forecasting ensuring that they use all the available data from all the different data sources, it is setting up itself for success to better understand where there are foreign exchange exposures and what needs attention.
Unforeseen events & global supply chain
Events that are difficult or almost impossible to foresee, like disruptions in supply chains (for example due to recent force major events, like COVID-19 and the war in Ukraine) or currency volatility and inflation. These events can come as a surprise and negatively impact the earnings of a company. The best way to deal with it is to have foreign exchange hedging strategies in place and once the unforeseen event occurs, try to deal with the situation according to the company’s FX policy.
The global supply chain is a complex machine and still today, companies struggle with gaining more transparency and visibility into their supply chain operations due to the lack of communication and data sharing between parties. This naturally affects the accuracy and reliability of the forecasts and can result in hidden or even unexpected FX exposures.
Shifting interest rates
The currency exchange rate is a determinant of a country’s economic health and therefore plays a vital role in a country’s level of trade. Therefore, managing foreign exchange risk when the interest rates are shifting is an important yet complex task. It’s been studied by economists that there is a correlation between foreign exchange and interest rate risk. When interest rates are increasing, lenders can get a higher return on their investments compared to other countries with lower interest rates. When interest rates attract foreign capital, the foreign exchange rate will naturally rise. However, the opposite is also true: when interest rates are decreasing, the exchange rates will also experience a drop.
Therefore, shifting interest rates – regardless of whether they move negatively or positively – should be a signal for FX risk professionals and they should have the tools and strategies in place to either mitigate the risk of decreasing exchange rates or reap the benefits of increasing exchange rates.
How to start with FX Risk management?
To effectively manage FX risk and identify the best hedging methods of foreign exchange risk, start with creating an FX policy, make sure you have all the data at your disposal, and you understand the FX risks that your organization is facing. In addition, adopting a cash flow at risk KPI can be beneficial to calculate the level of risk in relation to the company’s risk-bearing capacity.
Create an FX policy
An FX policy will be different at each company as it largely varies on the industry, the nature and complexity of the business, or on the countries where the subsidiaries operate.
Yet, it’s essential to set out a strategy. Ideally, companies would create their FX policies when the market is calm, as any force majeure events may influence a biased policy. While a policy should be a living document that’s revised whenever it is needed, think of it for the long-term instead of just a couple of months to make sure that the treasury provides the business with protection for when unexpected events occur.
When you need an FX policy, obviously, the business deals with multiple currencies. As not all currencies are created equal, try to understand which currency could have the biggest risk and negative impact on your operations and prioritize your hedging strategies accordingly.
While creating a policy is typically the responsibility of the CFO, having support from the Board of Directors is key. Once you have signoff from them, communication will be your next challenge. It’s essential that all stakeholders understand the policy and act accordingly.
Collect the data from all systems
Capture the financial positions from all your systems like ERP and seamlessly integrate them with your FX risk management solutions as soon as the trades and payments are concluded to start to deal with FX exposures and risk calculations. Using a single system for FX risk management that’s integrated with all your financial systems and ERPs will ensure that you are working with all the data you have close to real-time.
Identify the FX risks
You need to identify which currencies have the largest unhedged positions and whether the current hedging ratios are within the pre-defined ranges. To get an answer, you need to be able to get an overview of the gross exposure associated with different positions and predict cash flows in non-functional currencies, preferably displayed by currency pair and subsidiary.
Once you have identified the risk, make sure that you also quantify your company’s net exposure to the FX market.
Let’s say you need to buy Currency X for 5 million euros, and you receive Currency X for 2,5 million euros. Now, you will calculate the impact of owning Currency X by looking at the market over the last decade to understand the average Currency X vs. Euro fluctuation in percentage. If the average fluctuation was 10%, the impact of this foreign exchange could be €250 000. You should also consider extreme cases when the currency fluctuated significantly more than the average and what could be the quantitative impact if that scenario occurred.
Adopt a cash flow at risk KPI
Using the cash flow at risk as a risk parameter has the advantage of being able to present the foreign currency exposure in euros. Cash flow at risk highlights the level of the calculated risk in relation to a company’s risk-bearing capacity. With FX risk software, the above-mentioned example can be done automatically for each currency.
Managing FX risk can boost profit margins
Unhedged FX exposure means that the profitability of businesses may suffer as it can impact the earnings negatively. Consequently, managing FX risk efficiently by hedging currencies could improve the profitability of the business, thus investing in a solution that can help navigate the foreign exchange market can have a big advantage. With the current economic climate when economists are expecting interest rate rises when there’s unexpectedly high inflation across Europe after the tough times of COVID-19 and in the middle of the Ukraine war, CFOs and treasurers cannot neglect FX risk management and its possible influence on the balance sheet.
Dealing with foreign exchange risk effectively can support the business with a competitive edge, as when you are hedging currencies effectively you will see the best possible return on your international investments, and you can better forecast when a currency is likely to decrease and you can act upon that.