What is foreign exchange risk management & risk mitigation techniques

11 min read

Multinational companies, import-export businesses, investors, and individuals making international transactions face foreign exchange rate risk. Exchange rate fluctuations are a daily occurrence. As the value of major currencies fluctuate against each other, it creates income uncertainties for anyone doing cross-border transactions.

For instance, a company's income statement can drop into the red based on a single exchange rate movement. Thus, there is a need to mitigate this risk through efficient exchange rate risk management strategies.

Looking for ways to mitigate foreign exchange risk? Read on as we’ll take a deep dive into foreign exchange risk management and mitigation strategies.

So, what is foreign exchange risk management?

The most basic way to reduce currency risk is investing or buying and selling only in your local currency. However, how sustainable is this approach? You run the risk of:

  • Losing customers to competitors that offer currency flexibility.
  • Losing suppliers that aren’t willing to receive payments in a foreign currency.
  • Losing out on some great investment opportunities in overseas and emerging markets.

You need to test different methods to minimise the risks as much as possible. Regardless of how you choose to do it, find a money transfer service such as Clear Treasury that can easily and quickly meet all your cross-border transfer needs.

Understanding foreign exchange risk

When a country's currency depreciates in relation to other currencies, its goods and services become cheap for foreign buyers, and the opposite is also true.

Unless exchange rates are fixed in relation to one another, many entities will have to deal with exchange rate risk, which typically shows itself in three main ways:

Stock Exchange

1. Forecast risk

Forecast risk, also known as economic risk, arises when unavoidable exposure to currency fluctuations adversely impacts a company's market value.

For example, changes in the macroeconomic conditions, including political stability, government regulations or exchange rates, can lead to changes in the relative prices of inputs and outputs.

The relative changes in price can adversely affect a company's market share, future cash flows and value in the long run.

2. Transactional risk

Transactional exposure is the risk that the exchange rate will change between the date you make the agreement and subsequent transaction dates when you settle the deal.

The rate on the date you agreed might differ significantly from the settlement rate. For instance, say you sell shares in a foreign stock exchange on date X. When you receive your funds a few days later, you may get much less than anticipated if the exchange rate moves adversely.

3. Translation risk

This risk affects companies headquartered domestically but with subsidiaries in foreign jurisdictions. Translation risk, also known as accounting risk, occurs when the subsidiary's financial statements, such as the balance sheet, must be consolidated into the parent company's financial statements.

If the exchange rate fluctuates, it impacts the performance of a subsidiary. The translation risk will be higher if the parent company holds a significant portion of its assets, liabilities or equities in a foreign currency.

How to mitigate foreign exchange risk

The first step is to determine the primary objective of your foreign exchange risk management.

For some, it is to reduce the risk while making moves to benefit from the arbitrage and economic opportunities arising from exchange rate movements.

For others, it is to protect themselves from the adverse impact of exchange rate fluctuations.

Once you get a handle on the ‘why,’ you can develop the right policy based on suitable strategies to manage your foreign exchange risks.

To understand why you need foreign exchange risk management:

  • Identify and quantify the risks to determine the magnitude of exposure you face.
  • Formulate a policy based on your objectives.
  • Determine the appropriate exchange risk management strategies to use.
  • Implement and execute your strategy.
  • Regularly monitor if it’s working and revise if you need to.

Foreign exchange risk management strategies

Here are some strategies you can use.

1. Forward contracts

A forward contract is a foreign exchange agreement where you lock in the exchange rate of a future foreign currency payment today.

It allows entities to protect themselves from exchange rate movements by entering into a contract with a third party such as a reputable international payment provider like Clear Treasury.

Strategy tips

  • Calculate the cost or benefit of buying forward when you purchase. The benefits should outweigh what you pay for signing the contract.
  • For major trading currencies, such as the US dollar or euro, the contract can be up to 10 years forward.

2. Currency futures

Futures contracts are standard legal agreements between two parties agreeing to buy or sell a given amount of currency at a later date, at a specific fixed price. You can use futures to lock in favourable prices for a transaction you need to make in the future.

Strategy tips

  • You can trade futures in organised exchanges; thus, they are very liquid.
  • You can hedge a depreciating currency by selling futures and an appreciating one by buying futures.

3. Currency options

Options give companies the right, but not the obligation, to buy or sell the currency at a specific exchange rate, called the strike price, on or before a specific date when the option expires.

Strategy tips

  • Options give the holder the choice to buy or sell the currency or let the option lapse based on the exchange rate, so they are flexible.
  • The flexibility to exercise the option or let it lapse comes with a price referred to as the option premium. So do your calculations carefully to determine which risks are worth using options and which ones aren’t.

4. Currency swaps

Swaps are contracts that involve an agreement between two parties to exchange cash flows in one currency for a series of cash flows in another currency. This exchange occurs at agreed intervals over a set period.

Strategy tips

  • Swaps convert liability in one currency to another, and each party pays interest for the exchanged currency at regular intervals.
  • Swaps often take place between corporations with international operations or between commercial banks.

5. Hedging with specialised ETFs

Investing in long- or short-term specialised currency ETFs can protect the value of your investment from currency volatility. While it functions like any other ETF, currency ETFs hold currency cash deposits or financial instruments tied to an underlying currency that mirrors its movement.

Examples of currency ETFs include the ProShares UltraShort Euro ETF or the Invesco DB US Dollar Index Bullish Fund.

6. Hedging with CFDs

In a contract for difference (CFD), you agree to exchange the difference in the price of a currency from when the position opens to when it's closed. Thus if the market moves in the predicted direction, the investor profits, but if it moves in the opposite direction, they make losses.

7. Invoicing in the local currency

One of the easiest ways to hedge against the exchange rate risk is receiving and making payments in your local currency.

This strategy does not do away with the risk. Instead, it passes it on to your customer or suppliers, an unrealistic approach in a competitive environment.

8. Netting

Netting involves offsetting exposure in one currency in the same or another currency. In this system, subsidiaries deal only with their local currency, leaving all the transaction exposure to the re-invoicing centre.

The centre nets all exposures in one place, ensuring the entire firm follows consistent policy. It also lowers transaction costs because of the centralised netting system. Each subsidiary can concentrate on what they specialise in.

9. Matching

Also known as natural foreign exchange hedging. To minimise net exposure, a firm matches its receipts (inflows) and payments (outflows) in the same foreign currency regarding the amount and timing.

It only has to deal with exchange rate risk management for the unmatched portion of the total transactions.

10. Leading and lagging

Leading involves rushing payments for goods or investments denominated in currencies that you think will become stronger. You will also speed up receipts of weakening currencies.

Lagging is delaying payment of weakening currencies or receipt of strengthening currencies.

Leading and lagging help companies benefit from the movements in exchange rates, but it’s largely speculative as you can not accurately predict how a currency will move.

In a nutshell

  • Foreign exchange risk is part and parcel of doing international business or investing in other countries.
  • Currency fluctuation may adversely impact your operations and investments, leading to income uncertainty and losses.
  • Types of foreign exchange risks include economic, transactional, and translation.
  • External foreign exchange risk mitigation strategies for hedging against transactional risks include forward contracts, currency futures, currency options, and currency swaps.
  • Internal foreign exchange risk mitigation strategies that you can implement include invoicing in local currency, netting, matching, and leading and lagging.

Foreign Exchange

Get expert exchange rate risk management help

Getting rid of uncertainty brought about by exchange rate volatility or taking advantage of these fluctuations’ opportunities can be highly complex and time-consuming.

Don't hesitate to get help and expert advice. Turn to Clear Treasury today to get access to:

  • A dedicated online platform
  • A guaranteed competitive exchange rate
  • Smooth transactions and lower exchange complexities
  • Advice on how to handle exchange rate risk management
  • Cost-effective transfer processing

Focus on your business or investments and let Clear Treasury handle complicated exchange rate issues for you.

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