Regulators have spent the better part of the last decade working tirelessly to produce international frameworks capable of better servicing the world’s increasingly globalised financial markets. Yet while considerable progress has been made across particular sectors, shifting domestic monetary policies and intense political uncertainty around landmark events like Brexit and America’s trade war with China have led to some major regulatory divergence between key markets.
This divergence inherently creates serious problems for organisations operating across multiple jurisdictions – which is why treasury teams must now work harder than ever to manage foreign exchange (FX) risk.
When a company is trading in more than one currency, that organisation faces an acute risk its financial performance and profitability could fluctuate dramatically as a result of unstable exchange rates between currencies. That said, even businesses operating in one market alone are often indirectly exposed to foreign exchange risk through their global supply chains.
A falling domestic exchange rate will typically increase the cost of importing and lead to a dramatic increase in a company’s cost of capital expenditure. It can also make investing overseas more expensive, and the cost of servicing foreign currency debts will rise, too. On the flip side, when domestic rates rise, exports become less competitive. That pushes down dividends, which can subsequently decrease a company’s market value. Yet the cost of foreign inputs will also normally decrease, giving importers a competitive advantage over domestic firms.
It’s worth pointing out FX risk can also present multinationals with a range of positive opportunities for growth – but only if treasurers are efficiently measuring those risks to make informed decisions about how exposures can be effectively managed.
How to measure foreign exchange risk
When treasurers are working to manage foreign exchange exposures, there are several different types of risk that must to be identified and measured.
First and foremost, there’s the economic risk that comes hand-in-hand with FX. Organisations must closely monitor the macroeconomic conditions that inherently impact foreign exchange rates, such as incoming (or outgoing) regulation, political uncertainty and rising interest rates. All of these factors tend to have adverse effects on a company’s net cash inflows and competitiveness – which is why companies have got to monitor the economic risks associated with dealing in multiple currencies.
Treasurers must also keep a close eye on transaction risk. Transaction risk is generated by the fluctuations in exchange rates that occur in between the signing of a transaction and the execution of that transaction.
Similarly, translation risk is another key consideration companies must bear in mind. Translation risk arises when currency variations occur between the time in which funds are received or exchanged and when a firm reports its quarterly or annual financial statements. This is often the biggest risk associated with FX, because when a larger proportion of a company’s assets and liabilities are denominated in a foreign currency, rate changes could then lead to significant changes in the value of those assets.
Fortunately, there are plenty of tools treasury teams can deploy to monitor each of these risks and how they’re affecting a company’s financial position.
One of the simplest methods an organisation can utilise is to create and maintain a register of exposures and any associated FX hedges in which all the details of each hedge can be recorded against any relevant exposures. In some jurisdictions, maintaining an FX exposure register will also help organisations to meet their regulatory obligations around accounting standards under rules like Dodd-Frank and MiFID II.
Another basic way in which FX risk management can be measured is to create and monitor projections of foreign currency cash flows if the business in question is both paying and receiving foreign currencies. By projecting cash flows, treasurers will be able to tell whether the business is in surplus or lacking in certain currencies to make better informed decisions about where and how resources can be efficiently deployed.
A lot of multinationals will want to take these projections a step further by conducting a regular sensitivity analysis in order to calculate the potential effects of major exchange fluctuations on any number of business-critical activities. These analyses are ordinarily conducted by using historic rate changes and are also incredibly useful for companies that are reliant on commodity prices as they may relate to foreign currencies.
Financial institutions in particular tend to use a probability approach rather than rely on historic rates when it comes to sensitivity analysis. This approach is referred to as the ‘value at risk’ model and enables treasurers to not only understand the impact of any given FX shift, but also how frequently such changes are likely to occur. In turn, the value at risk approach allows companies to maintain a high degree of certainty they are adequately equipped to weather rate changes with minimal losses.
How to manage foreign exchange risk
Managing FX risk is intrinsically trickier than identifying or measuring potential exposures, because every business has its own unique financial position and appetite for risk. Yet regardless of an organisation’s business activities or willingness to entertain higher degrees of FX risk, there are several key tools and products financial leaders can implement to appropriately manage foreign exchange risk.
The first management tool worth exploring is a forward exchange contract. A forward exchange contract helps insulate companies from large currency movements by locking in an agreed rate up to a predetermined date. Because rates are fixed from the outset of any agreement, forward exchange contracts are ideal for exporters wanting certainty around the amount they’ll be receiving as part of a given transaction.
According to the London Institute of Banking & Finance, forward exchange contracts tend to be the most popular method in order to manage FX volatility – although it’s worth pointing out these fixed rates can also prevent corporates from taking advantage of positive exchange fluctuations that would have worked in their favour, as importers are contractually bound to accept the pre-agreed rate regardless of current FX rates.
Another management solution is to deploy a foreign currency option. This is essentially an insurance agreement against adverse currency fluctuations that empowers a firm wanting to buy or sell foreign currencies with the right to carry out the transaction at an agreed future date. A premium is normally required to secure a foreign currency option, and these premiums are often pretty expensive. Yet the added protection against downward movements in local currency values are typically worth that price for importers, while still enabling corporates to benefit from value increases in their own local currency against other currencies.
Entering the futures market and implementing a hedging programme is a popular option, too – and one of the most creative programmes a corporate could possibly pursue is a so-called perfect hedge.
A perfect hedge is when a corporate builds up a position in which it can 100 percent match all outgoing foreign currency payments against its foreign currency inflows. In theory, a perfect hedge is an ideal risk management tool because it should totally eliminate the risk of an existing position. That being said, this method isn’t the most popular because of the uncertainty around cash flow timings – and unless an inflow and outflow are occurring at the exact same time, it doesn’t really count as a ‘perfect’ hedge.
Finally, treasurers are increasingly using alternative risk management methods like foreign currency bank accounts or loan facilities to manage FX risk when there’s a sizeable anticipated time gap between inflows and outflows. By depositing surplus foreign currency in a foreign bank account for later use or taking out a loan in foreign currency to pay for currency purchases, businesses are often able to hedge against exposure even if that exposure is just limited to receipts or sales. Foreign currency accounts also enable firms to eliminate conversion costs and correct surplus balances at a prevailing spot rate.
Unfortunately, there’s no textbook powerplay all treasurers can utilise to manage FX risk. Each business has its own appetite for risk. Yet by actively monitoring each aspect of that risk and using data to appropriately manage sustainable levels of risk, treasury teams should be able to successfully navigate shifting FX markets in order to capture opportunities for growth.