Your Brief 3-step Plan: Building an Expert FX Strategy That Truly Offsets Risk

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A high amount of SMEs with considerable operations in foreign currencies don't protect themselves against FX risk. These companies, many of which record revenues of around $200 million per year, simply don't approach FX management because there is no specialist in-house FX risk manager. Instead, they expose themselves to the whims of the currency market.

Foreign exchange volatility left unchecked can create cash flow problems and make a considerable dent in profit margins.

As we have witnessed in 2018, with the Turkish lira crisis in particular and its knock-on negative effect on emerging markets, foreign exchange volatility left unchecked can create cash flow problems and make a considerable dent in profit margins. Join us in this brief article as we outline the three main areas for an effective corporate FX plan that protects your organization from market risk and generates value-added results.

1. Planning and budgeting

A strong FX strategy requires a watertight foundation based on astute, comprehensive planning and budgeting. Planning your overall FX strategy is not a task to be taken lightly. It necessitates a thorough analysis of the areas of business that are exposed to the currency market, the level to which your organization can absorb FX losses, the tools and hedging product options in your arsenal, and your budgeting forecast for the year ahead.

Unfortunately, many companies budget with overly optimistic forecasts in mind. Forecasting is a difficult task for any treasurer or CFO, but including lofty sales and revenue goals in a budgeting plan makes it more difficult than it has to be. Better to forecast conservatively, especially if you have to include accounts receivable and payable in foreign currencies, especially from emerging markets. It is also advisable to budget based on your minimum acceptable exchange rates. Your hedging strategy can help ensure you achieve at least these rates on your inter-currency transactions, which we will discuss below.

Sharper forecasting leads to a more realistic view and positions your treasury better for when exchange rate volatility strikes.

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2. Identifying and measuring your FX risk

To offset risk, you must first establish where you are potentially vulnerable. CFOs must first assess the following:

  • What is our total volume in FX exposure?

  • What are our exposures for each individual currency we operate in?

  • What business areas are especially exposed to FX risk?

Ascertaining these three points helps you to understand your risk better and creates the base from which to develop a risk protection process. Your treasury can measure your risk by compiling your historical transactional data in foreign currencies. You can also use real historical FX market data as a comparison tool, to assess volatility, and to see the impact on cash flow that locking in an exchange rate for a given period of time generates, such as 6 months or 12 months.

3. Risk hedging and currency market analysis

It is never a good idea to take on the FX market, as at best it amounts to gambling with your organization's finances, and, at worst, high-risk negligence.

Through establishing your organization's risk tolerance—the degree to which you can absorb FX losses—and accurate, realistic budgeting, you will have a much better idea of the percentage of your exposure that you want to hedge. After all, if you hedge all of your exposure all of the time, it amounts to not hedging at all. Your next decision is to which of your FX products of choice to hedge with. A mixture of spot trades and forward contracts offers a simplified yet effective foundational point to optimize your transactional position and lock in exchange rates for a given period.

Some additional rule of thumb include:

  • A willingness to lock in a loss should the market move against you in order to protect yourself from further risk

  • Avoid complacency creeping in by scheduling regular periodic strategy and execution reviews with your treasury department, such as once monthly

  • Keep up to date with FX market movements, volatility drivers, and currency forecasts

Companies with a global outlook must enact and maintain a stringent FX risk strategy.

Wrapping up

Currency markets have seen numerous crises in the last five years, including sizable exchange rate movements for the Swiss franc, Russian rouble, British pound sterling, Argentinian peso and Turkish lira. With other concerning, sudden macroeconomic developments such as the ongoing trade war between the U.S. and China, companies with a global outlook must enact and maintain a stringent FX risk strategy.

Investing the time and resources in following this three-step plan, while leveraging data-rich tools and FX products to power your strategy will reap dividends by protecting your profit margins, and helping maintain a healthy cash flow.