The currency market is the largest investment market in the world, with an average daily volume of about five trillion dollars. Foreign currencies can fluctuate in value because of inflation, unemployment, or election results. Volatility can also be triggered by other news or global events like weather or pandemic. Running a business that is exposed to the foreign exchange market means you will always be subject to foreign exchange rate risk. Throughout each week, the value of different currencies is always in flux—from hour to hour and from day to day. For businesses, this can result in a substantial profit or loss. The problem of how to best manage foreign exchange volatility has plagued multinational companies for decades. That is why so many companies are struggling to manage their currency risk in the right way. This guide provides an overview of the issues associated with understanding and managing foreign exchange risk and will help you to protect your company's finances from a sudden market shift.
What are the risks in the foreign exchange market?
Foreign exchange risks can be classified into the following three types of risks:
Transaction Risk - Any time a company receives or sends a payment in a foreign currency, there is a risk of the exchange rate changing before the transaction is complete. If the rate moves against you, the transaction will cost more and have a significant impact on the company's bottom line.
For example, a European company with operations in USA is looking to transfer 500 USD in earnings to its European account. If the exchange were 1 euro for 5 dollars, and the rate subsequently falls to 1 euro for 6 dollars before settlement, an expected receipt of 100 euro (EUR 500/5) would instead be worth 86 dollars (USD 500/6).
Translation Risk - Refers to the risk that a company’s equities, assets, liabilities, or income will change in value as a result of exchange rate changes.
For example, a parent company that reports in Canadian dollars but oversees a subsidiary based in China faces translation risk, as the subsidiary’s financial performance – which is in Chinese yuan – is translated into Canadian dollar for reporting purposes.
Economic Risk - Currency rates can fluctuate based on the economic situation of the countries whose currency you’re trading. These may be affected by various factors, such as world news, political actions interest rates, Inflation, and the economic health of the country. The economic risk can have an impact on a company’s market value and operations from exposure to unexpected currency fluctuations. This can affect a company’s future cash flows, foreign investments, and earnings, not only for the near term but also for the long term.
How Hedging Tools Can Help You Manage the Risks in the Foreign Currency Market?
Hedging is a technique to reduce exposure to measurable types of risk in financial market transactions. It is a type of insurance, and while it cannot eliminate risk completely, hedging can mitigate the effect. The correct hedging tools will depend on the types of assets or transactions involved. For a company with international operations, the use of currency hedging tools is very important when converting foreign income into the home currency or purchasing inputs or equipment overseas. Here are some of the common hedging tools that will help you protect your business from the movements in the
Forward contracts give your business the freedom and flexibility to take the unpredictability out of currency conversion and budget effectively to protect your profit margins from negative market movements. This means no more worrying about exchange rate volatility. In effect, forward transactions fix the future exchange-rate, eliminating the currency rate risk. Regardless of which direction the market moves you will know the exact cost of the foreign currency amount you need when you are ready to make a transfer. The best part: you don’t have to pay anything until the currency is actually needed, keeping that cash free for other uses; in other words, planning and budgeting just got a little more stress-free. The Forward Contracts is especially useful for businesses that forecast payables into the future. If a payment is coming in 90 days from now, there can be a lot of fluctuation in the currency market between now and then. But by locking in a rate today, you can plan for profits while protecting against market volatility.
FX options are effectively an insurance policy that can be a great way to hedge an investor's spot in currency market. An FX option is a transaction that confers on the holder the right, but not the obligation, to exchange an amount of one currency for another at a pre-agreed rate (strike rate) on or before a pre-agreed date. It provides protection against an adverse movement in the chosen currency at the agreed-upon strike rate. There are two types of options; A “call option” that gives the option to buy at a certain price and a “put option”, which gives the option to sell at a certain price. An option buyer (call option) would like the price of the asset (FX rate) to go up so that the trader can exercise his option to buy at a lower price at the moment and vice versa-the option seller (put option) would like the
price of the asset (FX rate) to go down.
What are the Top Common Mistakes That Companies Make in Currency Risk Management?
1. Not understanding the impact of the exposure to the currency market
If it is the end of the quarter and you need to close the books in a few days, can you adequately explain the exchange rate results to senior management with confidence? A company making some of the previous mistakes listed above would likely be unable to answer "yes" to this question. There is inevitably going to be a mismatch between the underlying exposures and the hedges meant to neutralize them, for several reasons. Intra-month adjustment trades, forecast deviation, mark-to-market calculation errors, forward points, and incorrect and/or catch-up re-measurement entries can all affect your results to various degrees at different times. The ability to quickly isolate these factors is critical in understanding your results and providing a quick feedback loop for your next period's hedging. Attempting to do this without the right tools can be a frustrating exercise and can feel like trying to find a needle in a
2. Misunderstanding of hedging
transactions’ goals and implications In many cases the company is not fully aware of the purpose of the hedging tool, its payment mechanism, and its implications. Over time companies forget why they executed hedging transactions and tend to evaluate their performance as a separate asset that creates profits and losses both economically and from an accounting perspective. This may lead to inadequate transaction cash-flow management (prematurely exercising hedging transactions when profitable) and even to stop hedging when hedging transactions show losses. Some companies choose not to hedge their economic currency risk due to accounting implications.
3. Not having a flexible hedging policy
Many companies that are exposed to currency market movements often have fixed predetermined current practices, and fear of change can be a significant obstacle to updating them. The problem with this is that many things have likely changed since a specific method or risk management policy was established, and various assumptions that may have been true years ago are no longer valid today. Currency risk policies tend to be implemented or updated over time in response to significant losses generated by exposures that weren't previously considered or well understood.
4. Not engaging enough with business partners
If you hedge your company's currency revenue exposure, do you fully understand the competitive environment in the various geographies where you do business and their respective specific pricing dynamics? Do you have any pricing power if there is a significant shift in the currency market? Whether your primary exposures are revenue or expense related, several factors would influence how much and for how long you should hedge, whether to use options or forwards, whether to layer in hedge rates, and how to interact with sales/procurement in terms of quoting/purchasing in local currency, and other considerations. A company may also need multiple strategies for differing product lines or business segments. An excellent way to test if a hedging strategy makes sense is to “stress test” it with different “What if?” scenarios, which should include modeling how you and your competition, suppliers, and partners would react.
4 Ways to Manage Foreign Exchange Risk With okoora ABCM ™
Since none of us have a crystal ball to accurately predict the future, guessing the future currency rates is a gamble that is best avoided. With okoora ABCM™ you can protect your business from exchange rate fluctuations -Minimize risks by locking exchange rates with AI-driven methodology and execute one-click rate protection. Here some of the hedging tools that okoora ABCM™ developed:
Lock rate & pay later- Whether you’re an importer or exporter, it can be frustrating to monitor the international market only to miss the ideal moment for a transfer. Let’s assume you want to buy something from a supplier in China, but you don’t really have to pay for it until several weeks (or months) later. You agree to pay the person the $100 worth of goods in their local currency yuan.
However, by the time your payment is due, you simply cannot guarantee that the $100 will have the same worth against the Chinese yuan. To avoid paying more, you create a forward contract to lockin your exchange rate, reserving current prices and protecting yourself against any market volatility.
With ABCM™ you’ll be able make the most out of your payments, and never miss out on any favorable currency rates. You can minimize any future cashflow uncertainty by locking the exchange rate when it seems most advantageous and keep current on what’s happening in global financial markets with AI-driven insights so that you can make real-time informed and confident decisions.
Compare hedge- Currency rate risk management is an important aspect of every multinational company’s business and having the right currency rate risk management strategies is crucial in order to achieve financial targets. However, currency rate risk management can be very complex and consists of different transactions with many differences such as costs, time ranges and profit and loss characteristics. okoora's ABCM™ Compare Hedge tool enables you to choose the right hedge strategy for your business. The compare hedge tool is supported by a smart optimization engine that chooses the most appropriate hedge strategy alternative for you from a wide range of possible hedge transactions.
Hedge policy- Your business depends on future cashflows and must have enough cash on hand to sustain operations, especially if it has overseas operations. It is difficult to come up with a hedging strategy that takes cashflow projections and market variables into account especially when your bank offers expensive hedging transactions that are not always suitable for you. ABCM’s hedging toolkit is powered by smart hedging methodologies and by a wizard that enables you to take the right action at the right time in order to minimize the uncertainties in juggling multiple currencies.
Limit board- Timing is everything. If your business depends on timely alerts to keep you on track, you can have multiple alerts competing for your attention. Keeping up and managing different reminders and alerts can often be quite challenging, and you may find yourself missing vital marketrelated alerts, causing you to make uninformed and costly business decisions. With okoora ABCM™ you can stay informed about what's going on in the global markets with timely alerts and AI-driven insights, so you can make informed and confident decisions in real time. With okoora's ABCM limit board you can set the rate you want to pay, and automatically execute the transaction when the market hits that rate.