Why do you need to have a currency risk management strategy?
Fluctuations in currency markets can potentially result in significant financial losses for companies. They can often eat away at profit margins through their impact on different business costs, for example, by increasing payables or reducing receivables. Companies with robust currency hedging strategies can take steps to mitigate these risks, but selecting an appropriate currency strategy can be fraught with complexities.
Smart Currency Business works with companies to create tailored currency hedging strategies to manage their foreign exchange (FX) risk, protecting their bottom line by conducting thorough reviews of the potential risks and their different impacts on the business.
Understanding and evaluating the risk
In order to create a comprehensive treasury management and currency strategy, the first step is to understand the different economic and business risks and evaluate their impact.
Currency market risk can be attributed to a number of economic and business factors:
- Transactional risk
Transactional risk relates to the exposure caused through regular business transactions and day-to-day business. For example, payables to overseas suppliers, receivables from the sale of exported goods and/or services, international intercompany payments, and funding/dividend exposures from overseas assets.
- Translational risk
Translation risk arises when companies conducting business in foreign markets need to translate the value of their overseas assets and liabilities into their home currency, in order to consolidate parent and foreign subsidiary financial statements. Fluctuating currency exchange rates can have a significant impact upon shareholders’ investments.
- Economic risk
Economic risk arises from the performance of global and domestic markets and their effects on your business.
Business factors contributing to currency risk:
Your company’s budget rate
Knowing your budget rate can be useful in helping you to make financial projections. In order to set your budget rate, you must assess the risk appetite of your business. This will also help you decide whether the right currency hedging strategy route for you consists of more straightforward currency products, such as spots and forwards, or more complex option solutions, where you can mitigate certain elements of adverse currency fluctuation risks. Your budget rate should be based on a realistic level, close to the current market rate.
Average transfer times
Quicker transfer times can allow you to pay for and make purchases on time, strengthening relationships with suppliers.
Seasonality/time of year
Is your business subject to large seasonal demands? What time of year is it in relation to your financial year-end? Are any key payables/receivables already anticipated or scheduled?
Which countries your company is regularly trading with and the strength of their currencies
Whether they are suppliers, manufacturers, importers, exporters, retailers or distributors, the countries that are home to your key business relationships and the strength of the corresponding currencies are crucial in assessing your risk.
The frequency and timing of currency transactions
Your currency strategies will need to be tailored depending on key factors, for example, the frequency of future payments along with the predictability of rates around the dates of these payments. If you only make occasional international payments, a spot contract may suit your needs. If you make regular payments to countries with volatile currencies, it is worth considering forward contracts? Or potentially a more sophisticated hedging strategy?
It is also important to match as closely as possible the cost of any raw materials or goods against predicted sales revenue, factoring in future market movements. For example, if sterling weakens unexpectedly against the US dollar, your pounds essentially buy less for the same money, and so this will need to be incorporated into your company’s currency hedging strategy. In this situation, it may be suitable to use US dollars from sales to pay for suppliers, manufacturers or staff in the US to minimise these effects.
There are numerous global and domestic economic risks, accompanied by your own business factors, that need to be considered when making overseas transactions. If you get it wrong, the losses can eradicate your profit, leaving you out of pocket. Creating and implementing the right treasury management and currency hedging strategy is therefore essential when trading in the international markets.