With the increasingly globalised nature of business, many companies find themselves exposed to foreign exchange risk. Global supply chains and cash flow involving different world currencies can present risks to a company’s finances if they do not have a proper understanding, firstly, of the necessity for hedging FX risks and, secondly, how to do so.
What is FX Risk?
FX risk refers to the risks posed to a company from fluctuating exchange rates and will vary in scale from business to business. There are broadly three categories of FX risk which companies need to be aware of; these are transaction risk, economic risk and translation risk.
What is Transaction Risk?
Transaction risk describes the potential losses which can be incurred due to a fluctuation in the exchange rate between the transaction date and settlement date. While obviously, the two-way risk here means that the fluctuation might benefit the business, it is the potential for downside that businesses need to mitigate.
How Can Companies Hedge Against These Risks?
Now that we have highlighted some of the most important examples of FX risk, let’s consider some of the methods companies can use for managing this threat.
Before considering the use of external tools a company can, first of all, consider how internal changes can mitigate these risks. For example, a company could require all customer payments to be made in the home currency while also paying for all imports in the home currency. While this would mitigate the transaction risk for the business, the costs would be passed on to the customer which could still impact business levels.
Another method would be to use the money market to hedge anticipated risks. In an example, where a company is hedging a future payment, they would make the transaction in the spot market for the same value of the future commercial transaction, essentially borrowing the domestic currency until the commercial transaction date. For a future receipt, the company would make a transaction in the spot market by selling the domestic currency and essentially borrowing the present value of the future receipt until settlement.
A better method would be to use FX forward contracts to manage these risks. This type of contract describes an agreement to exchange currencies at a pre-determined level on a fixed date. For example, where the UK exporter delivers goods on credit, the transaction could be completed using FX forwards which would remove the exchange rate risk by locking in a certain exchange rate. These contracts can be particularly useful where the company anticipates heightened exchange rate volatility due to political events or economic risk factors.