5 steps to manage your currency risk

The fluctuation of exchange rates is a daily phenomenon. From the vacationer planning a trip abroad and wondering when and how to obtain local currency to the multinational organization buying and selling in multiple countries, the impact of a mistake can be significant. If you think money and exchange rates are only a concern for bankers, it's time to think again. Currency risks affect all international businesses.

If you think that currency and exchange rates are something that only bankers need to worry about, think again. Many businesses are exposed to currency risk, whether they realize it or not. With the recent wild swings in global currencies, currency risk is back on the agenda for businesses with customers, suppliers or production in other countries.

As the coronavirus spread, March and April saw dramatic fluctuations in exchange rates. Strict regulations to contain the outbreak put a damper on the global economy, causing a corresponding drop in oil prices and stock markets.

The market is looking for safe havens, turning to the Japanese yen, the US dollar and the Swiss franc. Small currencies and commodity currencies suffered, in particular the NOK, le SEK, AUD, NZD and emerging market currencies, although some of the decline in value has reversed since April.

The key lesson is that if you run a business that generates revenue abroad or has costs in other countries, you are most likely exposed to currency risk. Events beyond your control could eat into your revenue and increase your costs.

So how big is the problem of managing exchange rate risks?

In a survey of 200 CFOs and nearly 300 treasurers conducted by HSBC and FT Remark, 70% CFOs said their companies suffered a decline in profits in the past two years due to avoidable and unhedged currency risk.

58% CFOs of large companies said that managing foreign exchange risk is one of the two risks that currently occupy the largest portion of their time; and 51% said FX is the risk their organization is least equipped to deal with.

Currency fluctuations also pose a threat to small and medium-sized businesses, but according to Nordea's late 2020 study, too many SMEs underestimate their currency risks.

Companies with a turnover of more than €2 million and a fair level of imports and exports report having suffered unexpected financial losses caused by currency fluctuations during the COVID-19 pandemic. However, almost half of SMEs did not protect themselves against them. The survey indicates that the main obstacles to risk management are related to lack of time and know-how.

On the other hand, managing your exchange rate risks can bring benefits to your business:

• Protect your cash flow and profit margins
• Improved financial forecasting and budgeting
• Better understand how currency fluctuations affect your balance sheet
• Increase in borrowing capacity

When exchange rates fluctuate, businesses rush to avoid potential losses. What currency risks should they hedge and how?

Types of currency risk

Basically, companies face three types of exposure to foreign exchange risk: transaction exposure, translation exposure and economic (or operational) exposure. We will examine these in more detail below.

Trade Exposure

This is the simplest type of foreign exchange risk exposure and, as the name suggests, arises from an actual business transaction in a foreign currency. The exposure arises, for example, because of the time difference between the right to receive money from a customer and the actual physical receipt of the money or, in the case of a creditor, the time between placing the order and settling the invoice.

Example: A US company wants to buy equipment and, after receiving quotes from several suppliers (domestic and foreign), has chosen to buy in euros from a company in Germany. The equipment costs 100 000 € and at the time of the order, the exchange rate €/$ is 1,1, which means that the cost to the company in USD is $ 110 000.

Three months later, when the invoice is due, the $ weakened and the exchange rate €/$ is now 1,2 The cost to the company of settling the same 100 000 € to pay is now $ 120 000. The exposure to the transaction resulted in an unexpected additional cost to the company $10 000 and may mean that the company could have purchased the equipment at a lower price from one of the other suppliers.

Exposure to translation

This is the translation or conversion of the financial statements (such as the income statement or balance sheet) of a foreign subsidiary from its local currency into the reporting currency of the parent company. This occurs because the parent company has reporting obligations to shareholders and regulators that require it to provide a set of consolidated accounts in its reporting currency for all of its subsidiaries.

In the continuity of the example above, Suppose the American company decides to set up a subsidiary in Germany to manufacture equipment. The subsidiary will report its financial statements in euros and the American parent company will translate these statements into USD.

The example below shows the subsidiary's financial performance in its local currency,euro. Between the first and second year, she increased her income 10% and achieves a certain productivity to limit cost increases to only 6%. This results in an impressive increase in 25% of net income. However, due to the impact of exchange rate fluctuations, financial performance is significantly different in the parent company's reporting currency, USD.

Over the two-year period in this example, the dollar strengthened and the exchange rate €/$ went from an average of 1,2 the year 1 to 1,05 year 2. Financial performance in USD looks much worse. Turnover would be down by 4% and the net result, while continuing to progress, is only up by 9% instead of 25%.

Economic (or operational) exposure

This last type of risk of change is caused by the effect of unforeseen and unavoidable currency fluctuations on a company's future cash flows and market value, and is long-term in nature. This type of exposure can impact longer-term strategic decisions, such as where to invest in manufacturing capacity.

In my Hungarian experience mentioned at the beginning, the company I worked for moved large amounts of capacity from the US to Hungary in the early 2000s to take advantage of lower manufacturing costs. It was more economical to manufacture in Hungary and then ship the product back to the US. However, the Hungarian forint then strengthened considerably over the next decade and wiped out many of the anticipated cost advantages.

Exchange rate fluctuations can greatly affect a company's competitive position, even if it does not operate or sell abroad. For example, An American furniture manufacturer that sells only locally still has to deal with imports from Asia and Europe, which may become cheaper and therefore more competitive if the dollar appreciates significantly.

5 Steps to Managing Your Business' Foreign Exchange Risk

Understanding where and how currency fluctuations affect a company’s cash flows is not straightforward. Many different factors, from macroeconomic trends to competitive behavior within market segments, determine how exchange rates affect cash flows in a given company.

1. Review your operating cycle

Review your business's operating cycle to see where currency risk exists. This will help you determine how sensitive your profit margin is to currency fluctuations.

2. Accept that you have unique currency flows

Every business is unique and this is reflected in your cash flows, but also in the structure of your assets and liabilities. It is essential to understand that currency fluctuations can have an impact and that the decision to hedge or not is not as simple as a roll of the dice.

3. Decide what rules you want to apply to your foreign exchange risk management – ​​and stick to them

An effective foreign exchange policy starts with a clear understanding of the company's financial objectives and the potential impact that exchange rate changes could have on them: if operating cash inflows and outflows are in different currencies, exchange rate changes can compromise the target company's EBITDA.

If the assets and liabilities are in different currencies, the revaluation of these assets with new exchange rates could compromise the net result of the P&L or capital ratio targets. The foreign exchange risk management policy ensures that, regardless of financial objectives, foreign exchange risks that could compromise these objectives are systematically monitored and mitigated.

4. Manage your exposure to currency risk

Especially when it comes to physical products, there is a lag between making business decisions and seeing the effects of those decisions on the company’s bank account. During this time, purchase and sales orders are negotiated, materials are shipped around the world, and goods are manufactured, stored, and delivered. 

article read: Everything you need to know about stock market price volatility 

Alongside this physical process, invoices are sent, reviewed, approved and eventually paid. During this time, currencies appreciate and depreciate. If the costs of materials and manufacturing are in a different currency than the sales revenue, these exchange rate fluctuations can easily wipe out the sales margins that the company used as the basis for its initial decision-making. 

Financial instruments can help mitigate this uncertainty that compromises the company's financial objectives. This is what we call the cover, and this ensures that the exchange rates affecting the company's bank account balances are not too different from those used in its decision-making.