FX Risk Management Best Practices: The 5-step Guide for SMBs

Risk Management

In this second installation of our new series on “The impact of foreign exchange on small to mid-sized companies" we look at five of the best practices that SMBs can follow to lower foreign exchange risk and focus on growth.

Doing business abroad can help your company grow but it is imperative to understand the risks involved prior to expanding. Currency exchange risk is one of the most pressing factors to bear in mind when operating in foreign markets. If poorly managed, your profit margins can be reduced, or worse, wiped out altogether if FX market volatility is strong enough.

To protect your company from FX risk and boost your growth, consider implementing these five best practices:

1. Identify your risk exposure

Types of currency risk exposure include transaction exposure, translation exposure, and economic exposure.

Transaction is the risk you incur when processing a transaction in a foreign currency, while translation exposure is when you have assets and liabilities that are denominated in a currency that is not your domestic currency. Economic exposure is the risk that the current values you attribute to future cash flows could change based on exchange rate movements.

All three types of exposure may be impacted by further types of risk, including country and interest rate risk. The first step in managing your FX risk is to comprehensively identify to what type of risk you are exposed, and where.

2. Measure your risk exposure

Once you have identified your exposure, it's time to measure it. This step shows you the extent to which your company is exposed to the whims of the foreign exchange market and will directly inform your currency risk management strategy.

Questions to answer here include:

  1.   What currencies are we exposed to?
  2.   What volume do we transact in each currency?
  3.   What time periods are involved for each transaction?
  4.   What are the impacts of negative exchange rate movements on our profit margins? What is our minimum acceptable exchange rate as a result?
  5.   Does it make more sense to use a reserve currency or should we pay in the local currency?

An accurate measurement system relies on the precise recording of monetary transaction volumes and the timing associated with the exposure. For an efficient risk management strategy, your treasury can develop an internal system to record all weekly, monthly, or quarterly accounts receivable and payable in foreign currencies.

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3. Understand all your options

SMBs can get caught in a bind through buying FX products they don't fully understand, not hedging enough of their exposure, or going in the other direction and hedging too much. A total understanding of the options you have available to help contain your FX risk is crucial.

Tactics that you can employ as part of your overall risk management strategy include:

  • Exposure netting
  • Hedging
  • Matching FX inflows and outflows

It is important to understand where each tactic can be employed to reduce your currency risk. Each can form a potent part in your company's strategy.

4. Develop your risk management strategy

Some small and mid-sized businesses simply do not hedge their risk when it comes to foreign exchange. This is dangerous if you have substantial operations abroad, as you run the risk of seeing your profits wiped out due to currency movements. Many SMBs choose a strategy based on a mix of spot transactions, locking in rates with forward contracts, and currency options. Your total exposure will directly inform the strategy that you employ and should be updated in tandem with any changes in your operations or currency movements that affect you.

There are three rules of thumb to bear in mind when devising your strategy:

i. Don't hesitate to lock in a loss. When an exchange rate moves against you, it may be tempting to wait for it to bounce back, but what if it worsens? Cutting your losses is often a recommended policy.

ii. Don't take on the FX market. Failing to hedge your risk and holding out for exchange rate movements in your favor amounts to nothing more than speculation with your company's money.

iii. Consider paying in the local currency of your foreign suppliers. This may increase speed of transactions, improve customer relations and lead to lower costs. Often to account for FX risk, suppliers will add a premium for receiving payment in a reserve currency rather than their home currency.

5. Keep it simple

For optimum results your strategy should be as simplified as possible. This is especially true for SMBs. Extraneous complications slow down processes, constrict resources, and can lead to costly mistakes. This is probably most applicable to the hedging products you use, although it applies to your entire strategy. There are many kinds of FX product, and some are extremely layered, complex, and pricey.

Keep it simple by avoiding products you don't fully understand or that contain features that you don't really need. They tend to come at a higher price, where a simple forward or options contract may better fit your needs.