Foreign exchange (FX) risk is an intrinsic part of doing international business. The values of major currencies constantly fluctuate against each other, creating income uncertainty for your business. Many businesses like to eliminate this uncertainty by locking in future exchange rates. But some businesses regard exchange rate movements as a profit opportunity.
The simplest risk management strategy for reducing foreign exchange risk is to make and receive payments only in your own currency. But your cash flow risk can increase if customers with different native currencies time their payments to take advantage of exchange rate fluctuations. You might also lose customers to competitors who offer more currency flexibility and your suppliers may be unwilling to accept payments in what is to them a foreign currency. So you may therefore find that competitive pressures force you to explore a risk management strategy that helps manage your foreign exchange risk more efficiently.
Hedging Foreign Exchange Risk
Simple FX hedging involving currency forward contracts is the heart of FX risk management strategies for many businesses and is built into their FX international payments platforms. Currency forward contracts "lock in" the exchange rate of a future payment in a foreign currency. For example, suppose you are an Australian importer of British woollens and have just ordered next year's inventory. Payment of £100M is due in one year, which at an AUD/GBP exchange rate of 0.5 means a dollar outflow of $200M. But if the exchange rate moves to 0.45, your inventory cost in dollars will increase by $22m, which could mean a hit of over 10% to your bottom line. To avoid this exchange rate risk, you could enter into a forward contract to buy £100M sterling in a year's time at today's exchange rate.
If you have a series of foreign currency payments to make – for example, if you are paying for supplies through an open line of credit arrangement – you could opt for a "window forward" contract, where exchanges may be made “on or before" a particular date. If your exposure extends over a long period, you could consider flexible forward contracts on a historical rolling rate basis. This risk management strategy allows you to enjoy exchange risk protection beyond the typical timespan of simple forward contracts.
Forward contracts lower foreign exchange risk and give you income certainty, but they prevent your business profiting from favourable exchange rate movements. You could build profit potential into your FX risk management strategy by judicious use of derivative instruments such as options and swaps. However, they can be expensive and difficult to unwind when no longer required. You may find that careful management of foreign currency cash positions with the support of a good FX service provider gives you greater flexibility and reduces your foreign exchange risk.
You can bring forward or delay payments to limit the impact of adverse exchange rate movements or benefit from favourable ones. If you are doing business in multiple currencies, you could also time payments and receipts to offset currency positions for currencies that tend to move together, such as yen and yuan. Real-time rate alerts on an FX international payments platform can help you manage the timing of payments to suit your foreign exchange rate risk appetite.
Whatever FX risk management strategy you use, if you are maintaining long-term trading relationships in foreign jurisdictions your FX exposures will require continual monitoring. Foreign exchange rates are influenced by the political, economic and financial fortunes of the markets they operate in. A good FX service provider will be able to give you access to economic data, calendars and exchange rate information. Watch this short video for a look at the key indicators you need to be aware of.