Financial markets are global beasts that transcend borders. Yet while regulators have spent the better part of the last decade working feverishly to unite various key international markets under equal frameworks, recent socio-political uncertainty in the United States, Europe and Asia has begun to chip away at this globalised financial infrastructure – generating heightened levels of forex risk for the huge population of international companies trading in multiple currencies.
Foreign Exchange (FX) volatility was cited as the single greatest strategic challenge for financial leaders in Deloitte’s most recent Global Corporate Treasury Survey, with 52% of treasurers surveyed citing political turmoil in key markets and the uncertainty surrounding Britain’s looming EU departure as unwelcome sources of FX risk. Yet while a majority of treasurers do seem to agree that forex volatility is a major threat to their organisation’s overall financial stability, 75% of the survey’s respondents simultaneously reported their company was not actively monitoring key risks using ‘at risk’ measures.
What’s more, nearly half of treasury teams are not undertaking regular sensitivity analysis as part of a wider risk management strategy – despite the wide availability of these real-time analytics tools across treasury management systems. This lack of visibility leaves organisations in a very vulnerable position indeed.
When businesses trade in multiple currencies, they’re open to the acute (and highly likely) risk that their performance and profitability will experience intense fluctuations as a direct result of shifting currency exchange rates. That being said, FX risk also poses a serious risk to businesses trading in a single currency, as they’ll be indirectly exposed to unfavourable fluctuations as part of wider global supply chains.
How does foreign exchange risk impact companies? Falling domestic exchange rates tend to increase capital expenditure and hike the cost of importing – simultaneously increasing the cost of investing overseas and servicing foreign currency debts. Likewise, strong domestic FX rates have the power to hurt exporters by suppressing market value and inevitably crippling dividends for shareholders. While domestic rallies hurt export businesses, importers tend to gain a competitive advantage under these scenarios because strong domestic currency rates will dramatically push down the cost of foreign inputs.
Forex isn’t all about doom and gloom. It also presents large companies trading in multiple currencies with plenty of opportunities for massive growth. Yet in order to leverage those opportunities, treasury teams have first got to learn to identify, monitor and subsequently manage the major types of forex risk as part of a wider corporate strategy. Fortunately, there are plenty of dynamic tech solutions available on the market that can help teams to implement and achieve these risk management strategies with virtual ease.
What are the major types of forex risk?
Before diving headfirst into treasury management solutions and forex risk management, it’s definitely worth highlighting the key FX risks and the cause of forex risks that treasurers must be actively monitoring – and the single greatest risk forex poses to organisations is economic.
Macroeconomic conditions like incoming regulatory frameworks in key markets, rising interest rates and political uncertainty will inherently shift exchange rates dramatically. After all, let’s not forget how sterling dropped an eye-watering 10% in a single day after the UK’s 2016 EU referendum vote. These economic risks will invariably affect an organisation’s net cash inflows, subsequently stifling competitiveness.
As central banks across the globe finally start to harden their stance on historically low interest rates, treasurers should be particularly monitoring interest rate movement. That’s because if rates rise in one market, that market’s corresponding domestic currency will inevitably strengthen because of the flurry of investment that tends to go hand-in-hand with a currency perceived to be able to provide stronger returns. Likewise, interest rate drops will often signal weakness to investors, hitting exchange rates hard.
Transaction risk is also a key consideration that treasurers must bear in mind as part of their organisation’s FX risk management strategy.
Transaction risk occurs when there are fluctuations in foreign exchange rates in between the period of time that a company has signed a transaction and when that transaction is actually executed. The longer the time differential, the greater impact transaction risk could pose to an organisation. It’s worth pointing out transaction risk unavoidably benefits one of the parties involved in each cross-border transaction – there’s just a whole lot of uncertainty around which party will actually benefit.
Another major cause of foreign exchange risk is translation risk.
Similar to transaction risk, translation risk takes place when there are exchange shifts that occur between the time in which funds are received by a company and the time in which that company reports its quarterly or annual financial statements. Translation risk poses particularly major implications for a company’s overall financial health and market value, because when a business has a large proportion of assets and liabilities denominated in foreign currencies, exchange fluctuations have the power to wipe away the value of those assets in the blink of an eye.
“Translation risk poses particularly major implications for a company’s overall financial health and market value”
Counterparty risk must also play a key role in any treasury team’s FX strategy. After all, in every counterparty transaction, there is the looming risk of dealer or broker default – and because legacy forex risk management products like forward contracts aren’t typically guaranteed by an exchange or a clearing house, volatile FX conditions could mean a counterparty is unable or unwilling to adhere to longstanding contract terms. That’s where innovative tech comes in handy.
How can tech help to manage FX risk?
Although we’re currently in the midst of a proverbial fintech renaissance, it’s worth pointing out that foreign exchange risk is not a recent phenomenon. Forex risk has been around as long as international trade, which is why there are a range of legacy FX risk management solutions that are still available to companies – and the reason they’ve survived the test of time is because they do work.
One longstanding FX risk management solution that remains popular today is the forward exchange contract, which is a product that can insulate firms from devastating currency fluctuations by locking in an agreed rate of exchange up to a predefined date. Forward contracts are great for exporters requiring certainty around how much they’ll be receiving for transactions, and there are a wide range of market players that offer varying levels of forward exchange contracts online. Yet while forward contracts are able to protect companies from negative FX shifts, they also prevent companies from reaping the benefits of favourable currency fluctuations.
Another more traditional approach to FX risk management is to utilise foreign currency options. Foreign currency options are simply insurance agreements that protect companies from currency fluctuations by enabling them to carry out foreign currency transactions at an agreed future date. Yet foreign currency options typically come hand-in-hand with pricey premiums, which is why they aren’t always a sensible decision for smaller importers and exporters.
“Over the course of the last decade, both legacy providers and scrappy start-ups alike have brought a range of FX-specific solutions to market”
That’s why the most affordable – and quite often, most effective – FX risk management solution is now to either invest in or upgrade an existing treasury management system (TMS) or enterprise resource planning (ERP) system with the ability to actively monitor, analyse and advise on forex risk. The good news for treasurers is that the market is absolutely spoilt for choice. For treasury teams, it’s simply a matter of tallying up a list of the necessary services and functionality required.
Over the course of the last decade, both legacy providers and scrappy start-ups alike have brought a range of FX-specific solutions to market that empower treasury teams of all shapes and sizes to integrate forex risk management tasks into their daily routine with minimal disruption in terms of time and resource. Standout software-as-a-service (SaaS) solutions work to simplify the monitoring of FX risk and are capable of enhancing hedge management by producing automated hedging schedules and integrated APIs that instantly pull all transaction data in order to develop position overviews by risk, currency and maturity.
Another benefit companies will enjoy by integrating a tech-led FX strategy is the ability to automate FX transactions themselves. Legacy forex risk management products like sorts, forwards, and conditional orders are not only now supported and easily integrated into new SaaS solutions, but treasurers can even automate early draws, net forwards and market orders based on the pre-defined conditional criteria of that company’s choosing. Although this might sound like a brave (and dangerous) new world to some organisations, it’s worth mentioning the best market players have all started to include multi-factor authentication processes in order to gain API access, as well as full oversight and permissions control. Fintech FX solutions are typically just as robust and protected as they are effective at managing risk.
Smart, in-built micro-hedging also addresses many of the inherent vulnerabilities that come hand-in-hand with manual hedging processes, as online FX risk management solutions are able to hedge each receivable or payable in real-time as that transaction occurs. With the added benefit of straight-through processing (STP), hedging workloads are totally automated and streamlined.
The vast majority of white label forex solutions also come with the ability to drastically bolster exposure management and offer both direct access to real-time exchange rates as well as market-to-market valuation through various transactional simulations, bank spreads and stress tests. Meanwhile, SaaS and cloud-based FX solutions will also empower treasurers with the ability to swiftly produce custom strategic, financial and regulatory reports – as well as publish IFRS statements and EMIR reports.
A lot of these FX tech solutions are designed as standalone systems, or as optional bolt-ons to existing TMS or ERP systems that can be installed or added to compliment balance sheet, cash flow and income statement oversight. Yet even with the benefit of full integration and end-to-end workflows, bear in mind that the market’s biggest providers now offer TMS and ERP solutions that come pre-equipped to monitor forex risks in banks.
Leading SaaS, cloud or on-premise environment TMS solutions are built to consolidate a variety of functions including cash management, hedge accounting, FX, in-house banking, interest rate management and bank connectivity into one, intuitive dashboard. Recent AI and machine learning upgrades have also vastly improved the forecasting process of these tools and have the ability to both simplify an organisation’s banking structure as well as free up working capital and liquidity through controlled automation.
At the end of the day, busy and fragmented treasury teams are getting pulled in too many directions in order to adequately monitor and analyse all sources of foreign exchange risk. There’s simply too much to get done, which is why organisations that want to better mitigate FX risk would do well to invest in a data-driven fintech solution capable of helping firms to navigate otherwise volatile foreign exchange markets. After all, it’s only by identifying and managing FX risk that treasurers can assist their organisations in capitalising upon new opportunities for international growth.