Exchange rate risk is unavoidable in international business - treasurers after all can't control currency fluctuations. But what treasurers can control is how they manage and minimise that risk, and the costs that come with it.
Without access to the right data, businesses won’t have an accurate view of their exposure, making it impossible for them to understand their actual exchange rate risk.
In this blog, we’ll break down how you can understand your exchange rate risk and the strategies you can adopt to minimise it.
Suggested reading: For more on how to manage your overall FX risk and exposure, check out our blog: How to Manage and Control FX Risk and Exposure
Transaction exposure and hedging
As an international business trading across borders, understanding your transaction exposure and hedging accordingly is one of the most important ways you can minimise your exchange rate risk.
There are three types of exposure: transaction, translation and economic. For many companies, transaction is the most worrisome exposure and where they focus much of their attention.
Transaction risk or exposure occurs when the currencies in which a business generates expenses or revenue strengthen or weaken. This means a potential loss in value or an increase in costs. The more volatile the currency, the more quickly the risk profile can change for any exposures a business has in that currency, so it is particularly important to de-risk exposures in these currencies.¹
One of the most effective ways to reduce your transactional risk is by deploying hedging strategies like forward contracts, options, and swaps.
- Forward contracts: An agreement that fixes the exchange rate for the purchase or sale of a currency on a transaction on a certain future date.
- Options: An agreement that gives a business the right to, but not the obligation, to buy or sell currency at an agreed rate on or before a specific future date.
- Swaps: An agreement where two FX contracts are made to buy and sell the same currency pair in the same amount, but with different value dates. When properly executed, these trades cancel each other out so that the only cost component is the interest rate.
How much you should hedge depends on the exchange rate risk of the currency pairs involved, and also your company's FX policy, which takes into account how your company's circumstances will impact its risk.
Understanding and reducing your overall exchange rate risk
To generally minimise exchange rate risk it’s important to identify how much you are exposed and in which currencies this exposure is mostly coming from.
Drawing up realistic business projections (or cash flow projections) is the first place to start. It’s common to have a 12-month view and then closely monitor the exposure on an ongoing basis as business realities change projections.
When business projections and a consistent monitoring process are set up, you can then take additional steps to reduce your overall risk:
- Predict currency changes: Assess what will happen if a currency moves by a certain amount in a different direction. For example, a risk model might analyse the exposure which occurs when a company that has a EUR or GBP accounting currency and is receiving some revenue payments in NOK, discovers that NOK has devalued against the EUR or GBP. In that example they’re going to get less EUR or GBP and should thus apply this knowledge to future trades.
- Book hedges to address the risk: The percentage of the risk involved in trades is often dependent on how soon the exposure will occur. For example, a company might want to hedge 90% of exposures occurring in the next few months, but perhaps 10 or 20% of those occurring in a year. For currencies where the likelihood of rate change is high, a treasurer may want to hedge a higher percentage of those exposures than other currency exposures that are due to occur at the same time.
- Monitor the hedge coverage: Similar to business projections, it’s important to have an ongoing accurate view of how existing hedge positions cover or do not cover exposure, so that future trades can be planned accordingly.
- Use digital tools: Many companies do the above in spreadsheets, but this manual work can introduce human error. It also requires a lot of work to map projections against current hedge positions and overlay interbank market rate data for forward contract terms, which is crucial for treasurers to have the ability to assess potential risk and also plan future trades. The right digital tool can simplify these processes and ensure that they’re performed to a good standard.
FX Hedge Check
Just’s FX Hedge Check is a digital tool that makes understanding and reducing risk easy.
FX Hedge Check gives users the ability to monitor business projections and hedges to check whether exposure has been covered, and keeps this data updated as business changes occur. The data gathered and analysed from FX Hedge Check is then presented in clear graphs so that you can understand current risk, and see whether you’re adhering to your business’s FX policy and strategy.
Keeping costs low when reducing exchange rate risk
When a company knows what hedges it wants to book, the next step is to ensure that it can make these trades on terms that have fair margins and the lowest costs possible.
At the moment, most businesses simply trust banks to charge them fair margins in their FX trades. Because businesses often don’t have access to the interbank market data that banks do, they have no choice but to trust them.
This trust, however, is often misplaced.
The margins bank charge can add up to a substantial amount: a report from Banking Circle revealed that banks are charging UK SMEs almost 2.5% of the value of FX transactions, equating to around £4 billion in costs. The same report also found that 42% of businesses surveyed said their bank’s fees for cross-border transactions were too expensive.²
At Just, an analysis of over 156 billion USD worth of trades has shown that companies that don't benchmark FX are paying up to 150% more than companies that do benchmark their FX trades.
Controlling FX costs is also important alongside controlling exchange rate risk.
Controlling FX costs with FX Benchmarking tools
In order to control costs, a company needs to benchmark its FX trades by using FX Benchmarking tools.
FX Benchmarking is the process of checking the rates that FX providers access in the interbank market, against what those providers offer to their corporate customers. Companies can benchmark the terms or quote from an FX provider while trading so they can get a fair deal before they agree.
Companies can also benchmark trades that have already been executed to compare those margins to what other companies have received and check if they got a fair deal in prior trades. They can then use this information to negotiate better terms in future trades.
For companies hedging to reduce exchange rate risk, benchmarking quotes while trading is key.
But for this to work effectively, the tools they use must have access to complete interbank market rates - and not just for spot transactions, but forward contracts as well.
Suggested reading: Every treasury team needs FX Benchmarking
Using the right tools to keep costs low while you reduce exchange rate risk
So how do businesses understand what they’re being charged, and therefore the overall cost of their FX trades?
Get access to the actual exchange rates
By using the right FX benchmarking tools, you can get access to real-time data from the interbank market to show you what's going on in the market, rather than simply relying on the information from your provider.
Plus, with tools such as Just's FX Benchmark, you get access to the forward rates too — something that other tools like Yahoo Finance don’t provide. This allows you to see what your costs will be to settle funds at different times in the future.
View your banks’ margins
By gaining access to the interbank market rates alongside your bank’s quote, you can compare the quote with the rates, providing visibility over the margins they're charging you. The best tools also help you compare that margin to what you have achieved in the past and what other companies are getting in the market. This will help you understand both the rates themselves and what a fair margin actually looks like.
This approach helps you take back control of FX trades in two ways:
- The exposure from unavoidable currency fluctuations is mitigated and more diligently accounted for.
- FX costs are clearer and more consistent as unfair margins are appropriately identified and challenged.
With visibility and clarity over cash flow, treasurers can properly demonstrate with data that they are in control of FX trading, strategy and risk.
Hedge your risk and minimise your exposure with Just
You can’t change exchange rates. But you can change the information you have access to and how you respond to those rates.
View, predict and monitor your transaction exposure and know what to hedge and when with FX Hedge Check.
Ensure you get the best margins for those hedges with FX Benchmark, which will show you margins while you are trading with your bank.
Use FX Analytics to benchmark historical trades, which will allow you to verify that your FX provider gave you the margins committed and also compare those margins to what other companies are receiving. Use this margin analysis to secure better terms in the future.
At Just, we’ve found that companies who use the Just platform have an 8-15x return on their subscription fee through FX cost reductions alone, and this is on top of other values related to controlling FX exposure and risk.