Understanding and Managing FX Risk

FinLync | October 11, 2021

Foreign exchange risk (FX risk) is a concern for companies with overseas operations or sales. Changes to currency movements can lead to changes in the value of cash flows and assets that may result in financial loss. So what is foreign exchange risk, and how can companies manage this type of risk effectively?

What is FX risk?

Global companies that have operations or sales outside of the U.S. have to deal with fluctuations in the relevant countries’ exchange rates, which can change considerably over time. In some cases, companies will benefit from those currency movements. But currency movements can also have an adverse effect, and they can take their toll on companies’ earnings and assets in a few different ways:

  • Cash inflows. If payments from sales are received in another currency, there is a risk that exchange rate fluctuations could reduce the amount the company receives. This is a form of transaction risk.
  • Cash outflows. Likewise, the payments a company makes for expenses or to pay vendors can be affected by currency movements, meaning there is a risk the company may need to pay more than expected. This is also a type of transaction risk.
  • Translation risk. When foreign subsidiaries’ financial statements need to be translated into the company’s reporting currency, this can result in translation risk. For example, the statements of a U.S. companies’ overseas subsidiaries might need to be translated into US dollar.

Let’s look at these types of currency exchange risk in more detail.

Transaction risk

Transaction is one type of FX risk that companies need to consider when operating or trading overseas. It describes the risks associated with transactions in foreign currency, and arises due to currency movements that can take place between agreeing and settling a contract. The longer the period of time between these two actions, the greater the risk will be.

There are two types of transaction risk to consider: balance sheet exposures and cash flow exposures.

  • Balance sheet exposure. This can arise when a company creates receivables or payables in a currency other than the company’s functional currency. These transactions will typically have a later due date than when it is originally created. Consequently, there is a risk that the amount that is ultimately received, paid or settled on the due date will differ from the expected amount because of changes to the exchange rate.

 

  • Cash flow exposure. There is also a risk that the value of future transactions – such as expected sales in the following quarter – will differ from the expected amount because of changes in the FX rates during that period. For example, if Company X quotes the price of a product in June to a potential customer, and the contract is signed three months later, there is a risk that FX rates will have changed during those three months – thereby reducing the value of the contract for Company X.

 

Translation risk

Unlike transaction risk, translation risk arises specifically in the context of drawing up consolidated financial statements. If the company has assets or liabilities in a currency other than the company’s reporting currency, there is a risk that the value of those assets or liabilities can change as a result of currency movements. This may be reflected in the company’s financial statements.

For example, a U.S. parent company might have a European subsidiary that has a manufacturing plant or equipment denominated in EUR.  The parent company will need to report those assets in financial statements filed in the U.S. – and that means translating the EUR value to USD. However, currency movements will mean that the USD value of the overseas assets can increase or decrease over time, which will then appear as a gain or loss in the company’s financial statements.

Economic risk

A further type of foreign exchange risk is economic risk. This type of risk arises from unexpected changes to exchange rates that are driven by factors such as regulatory change, changes to monetary policy and other geopolitical developments. Economic risk is a long-term risk that can have an impact on the company’s strategic decisions – for example, by making it less competitive than expected to manufacture goods in a particular overseas market.

Foreign exchange risk management

In order to protect the business from foreign exchange risk, companies can engage in FX risk management. This includes identifying, quantifying and managing FX risk exposures using a variety of different tools and techniques, with the company’s approach determined by its FX risk management strategy.

There are various strategies available for companies looking to manage their foreign currency exposure. First, of course, companies need to understand which foreign currency risks they are facing – and that means identifying all potential exposures and determining whether these need to be mitigated.

Exchange rate risk management can benefit the company in a number of ways. For example, it can protect the company’s assets, reduce the volatility of cash flows and earnings, and minimize translation risk. Effective FX risk management can also be important when it comes to remaining competitive in the marketplace. If a company doesn’t manage its FX risk, but its competitors do, it may face higher costs and be forced to charge customers a higher price as a result.

When it comes to managing foreign exchange risk, companies will need to have suitable hedging strategies and policies in place. Hedging is an important risk management technique, whereby companies take an offsetting position in order to reduce FX risk. This is achieved by minimizing the variance between what is expected, and what the company actually receives or pays.

Companies may need to overcome certain challenges when managing their FX risk exposures. These can include a lack of visibility over FX exposures, manual processes, inadequate forecasting and a lack of rigor in the company’s hedging practices. The use of disparate systems can also make it difficult to capture FX exposures effectively.

How can hedging help with currency risk management?

In practice, there are two major types of hedging to consider. On the one hand, companies can use natural offsets to reduce their risk exposures and thereby reduce the cost of risk management. When needed, companies can also undertake active hedging by using derivative instruments in the foreign exchange market, such as forwards and options.

  • Forwards. A currency forward is a hedging tool that locks in an exchange rate for a currency pair on a particular date in the future, based on today’s exchange rate. Once a forward contract has been purchased, the company has to use that contract, even if the spot rate would be more favorable when the time comes. So while this type of contract can protect the company from potential losses, it also lacks flexibility.

 

  • Options. A foreign exchange option, or currency option, gives the buyer the right, but not the obligation, to buy or sell a currency at a specified exchange rate by a future date. So, the buyer can choose to exercise the contract if it is beneficial – or they can let the option expire if the current spot market rate is preferable at that moment in time. As such, an option contract allows companies to manage FX in a more flexible way, and benefit from favorable currency movements instead of being locked into a particular rate.

So, if a company is looking to hedge a large foreign currency payable, there are a couple of strategies available:

  • The company can look for natural offsets and hedge the transaction by matching it with a receivable denominated in the same currency.
  • Alternatively, the company might use a financial instrument, such as an FX forward contract, to match the amount and due date of the payment in order to offset it.

Benefits of foreign exchange netting

A further approach to foreign currency risk management is the use of foreign exchange netting. Broadly speaking, the goal of netting is to offset different payables and receivables across the organization in order to reduce the company’s overall foreign exchange exposure.

Netting can take place on either a bilateral or multilateral basis. Bilateral netting includes only two parties, whereas multilateral netting is used to consolidate payments between a larger number of participants. This is achieved by using a netting system that collates different cash flows between a number of entities within the group, with a netting center acting as a counterparty. So instead of having to settle its obligations with every counterparty on an individual basis, each participating entity has a single net payment or receipt. Multilateral netting can be used to collate flows in several different currencies.

The benefit of netting is that it reduces the company’s overall need for FX trading, thereby saving FX volumes and costs. A modern netting system can also result in operational efficiencies.

Sensitivity or stress test analysis

Another consideration for FX risk management is the use of sensitivity or stress test analysis to measure potential movements in underlying rates. Sensitivity is the level to which an instrument is affected by changes in underlying factors. A stress test, meanwhile, is a way of determining the likely impact that could result from a particular scenario.

Hedge accounting

The goal of managing FX risk is to minimize the risk faced by the organization, rather than seeking to profit from currency movements. With that in mind, some companies elect to use hedge accounting as a way of minimizing the impact of changes in foreign exchange rates on a company’s earnings statement. This is achieved by removing the mismatch that otherwise occurs between recording the value of a derivative in the company’s P&L, and the date when the relevant cash flow actually occurs – thereby demonstrating the correlation between the hedge, and the items being hedged. As such, hedge accounting removes volatility from the earnings statement and ensures that the company’s financial statements match its performance more effectively and can also have a positive impact on the company’s creditworthiness.

Depending on a company’s reporting country, different standards will need to be followed when reporting the use of derivatives as hedging tools – namely IFRS 9 and U.S. GAAP. Hedge accounting guidance has been simplified in recent years: the Financial Accounting Standards Board (FASB) issued a new hedging standard in 2017 – and in 2018, accounting standard IAS 39 was replaced by IFRS 9 ‘Financial Instruments’. However, the complexity associated with hedge accounting can sometimes deter organizations from pursuing this approach.

FX risk management and the need for technology

In order to manage foreign exchange effectively, it’s important to have full visibility over your data – and that means making sure the right technology is in place.

For one thing, companies need to have access to one central location where they can view all regional activity. And while spreadsheets are still commonly used by many companies for FX management, they also come with a number of disadvantages: as well as the risk of error, the static nature of spreadsheets also means that information needs to be imported and exported on a regular basis. And that, in turn, means that treasury needs to spend time synchronizing and reconciling data, instead of devoting that time to managing FX risk.

Furthermore, effective technology can enable companies to carry out the reporting that is needed for compliance purposes, such as SEC disclosures and reports. In order to fulfil these requirements, FX technology needs to provide standardized data, as well as the required level of security.

Conclusion

Managing FX risk can be a complex undertaking – not least because of the many different types of FX risk that can arise – but it is also an essential activity for companies operating internationally. Effective FX risk management can play a vital role in mitigating the risk that currency movements will adversely affect the value of the company’s sales and assets. Above all, it’s important to note that for corporate treasury teams, the goal of managing FX risk is not to make a profit, but to minimize risk – and that technology can play a critical role in helping companies manage FX risk more effectively.