What CFOs Need to Know to Master Foreign Exchange

CFO Best Practices

Currency volatility has continued to negatively impact Apple in 2017, notably from Europe and China. In previous quarters, the company has lost billions due to FX volatility, including an astonishing $5 billion in Q1 2016. These FX woes exemplify that no company can escape currency volatility risk. They also underline the importance of an effective currency risk strategy. In this article, we look at five of the best foreign exchange management practices for CFOs.

1. Identify your risk

Your treasury department must know exactly what risk your organization is exposed to from operating in foreign currencies. This risk is typically divided into three categories: transaction risk, economic exposure, and translation exposure.

You are exposed to transaction risk if you buy or sell any foreign currencies. For instance, a manufacturing company based in the United States that imports parts from the U.K. and pays in British pound sterling is exposed to transaction risk.

Economic exposure refers to the potential impact that currency fluctuations can have on future cash flows. The more revenue a company receives from overseas markets, the greater its economic exposure.

You are at risk of translation exposure if you have assets or liabilities denominated in a foreign currency. Foreign exchange movements can affect such assets' value.

2. Measure your risk

   Risk measurement is essential in
   devising your currency management
   strategy and getting your team
   on-board to execute it.

After your treasury team has identified your types of risk, you can measure the exposure levels involved. Risk measurement is essential in devising your subsequent currency management strategy and getting your team on-board to execute it.

The treasury team can begin by gathering data on your overseas operations, including accounts payable and accounts receivable per foreign market. Treasury can also review historical transactions for currency volumes involved and currency fluctuations on and around past transaction dates. Moving forward, you can implement a reliable system of measuring all types of exposure.

3. Hedge your risk

Hedging has an unfair reputation for complexity. Some of the most effective hedging strategies are also some of the simplest, such as forward contracts and options.

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Form a strong hedging strategy that relies upon accurate, reliable market data to inform your risk management decisions. With a clear strategy and careful forward planning, finance teams can lock in exchange rates for up to one year. It's better to be safe than run the risk of damaging your cash flow. If you operate in minor or exotic currencies, good hedging strategy is even more urgent.

4. Never attempt to "beat the market"

Taking on the FX market amounts to little more than speculation. Yes, there can be upsides with exchange rate movement. If one currency in a pair goes down in value the other must go up after all, but it is very risky.

When your organization's cash flow is on the line, leaving foreign currency exposure to the whims of the volatile currency market can easily increase your costs or even wipe out profits made abroad.

As an example, a hypothetical U.S. company places an order with a Spanish supplier. The supplier issues an invoice with a 60-day notice period for payment in euros. If the U.S. company does not lock in a USD/EUR exchange rate and the euro strengthens against the dollar by 15% by the end of the 60-day period, the company will have to pay 15% more in U.S. dollars.

5. Regularly review your foreign exchange provider

Foreign exchange providers are not all the same—far from it, in fact. Your treasury team can protect your company's interests by regularly reviewing your provider. The following are some queries to bear in mind:

  • Is the exchange rate transparent? A transparent foreign exchange provider will disclose the percentage in points (pips) added to your exchange rate.
  • Is there an additional fee for delivery of funds? What is the transaction turnaround time?
  • What foreign exchange management tools and hedging products are offered?
  • Do they offer strategic support to your treasury and accounting departments? Is it personalized to your organizational needs?
  • What is their pedigree? Have they helped other companies similar to yours in size, sector and currency exposure? Do they prioritize client service?

In summary...

These five foreign exchange best practices for the CFO will help guide your organization towards a strong currency management process. In today's globalized business landscape, revenues that are dependent on overseas markets are increasingly essential to the success of corporates. Currency management can no longer be an afterthought, but rather it must be front and center of a CFO's drive to manage financial risk.