Understanding Currency Exposure: 7 Essential Terms you should Know
This article is written by GPS Capital Markets Imagine you are part of the finance department of an artisan chocolate producer in the UK. Renowned for its premium products, and your small to medium-sized enterprise (SME). Then you decide to import macadamia nuts from Hawaii to bring an great flair to its product offering. The idea sounds intriguing. But as you delve into the specifics of doing business internationally, the challenges with foreign currency exposure come to play. When engaging in international trade, treasury departments play a critical role in safeguarding an organization from risk. So, where should you begin? A solid understanding of key terms related to currency exposure is an excellent starting point. This knowledge will guide you as you make informed decisions for your company. We have compiled a list of top fundamental currency exposure terms and their definitions. Defining Foreign Currency Exposure Exposure to foreign exchange risk involves the potential for financial loss due to frequent changes in foreign exchange rates. These fluctuations can negatively impact transactions made in a foreign currency rather than in the company’s domestic currency. The concern for a company is that fluctuations in foreign currency rates could influence its future cash flows. This is due to the unstable nature of foreign exchange rates. It’s not only companies that engage directly in transactions denominated in foreign currencies that are at risk of foreign exposure. Firms with indirect connections to foreign currencies also face this risk. Products imported from China can affect an Indian company competing with them. This is if the value of the Chinese yuan drops against the Indian rupee. This can grant importers a cost advantage over the Indian company. This shows how shifts in foreign currency values can impact companies. Even if they do not engage in direct foreign exchange dealings. Foreign Exchange (FX) Hedging Foreign exchange hedging is a strategy used by corporations to protect themselves from the risks. These risks are associated with fluctuations in exchange rates. By locking in exchange rates for future transactions through contracts like forwards, options, swaps, or futures, companies can ensure financial predictability. This can also reduce exposure to adverse currency movements. Let’s say our UK chocolate producer expects to pay his Hawaiian supplier $100,000 in 6 months, it can enter into a forward contract to buy $100,000 at a fixed rate today. If the US dollar (USD) strengthens against the euro (EUR) by the payment date, the company is shielded from the increased cost. Because it is already locked in a more favorable exchange rate. This practice is crucial for budgeting, forecasting, and protecting profit margins in international business operations. To learn more about hedging instruments, explore the article, “6 Benefits of Incorporating FX Hedging Solutions.” Derivatives The term derivative refers to financial instruments whose value is derived from an underlying asset, like stock, bond, or currency. In the currency market, these instruments allow corporate treasurers to hedge against foreign exchange risk. This will ensure that currency fluctuations do not adversely affect the company’s finances. Common types include forwards, options, futures, and swaps. Types of Derivatives Currency Forward Contracts A currency forward contract is a binding agreement between two parties to exchange a specific amount of one currency for another at a predetermined exchange rate on a specified future date. For example, the treasurer of a US company that expects to pay a European supplier €1 million in three months for goods imported from Europe, may choose to hedge against the risk of the euro appreciating against the dollar by using a forward contract to lock in today’s EUR/USD exchange rate for the transaction. By doing so, the company knows exactly how much it will pay in USD, regardless of future exchange rate fluctuations, aiding with its financial planning. Also Read Currency Swaps Imagine you are a Canadian company, needing Japanese yen (JPY) for an invoice due to a Japanese supplier in six months, but currently holding Canadian dollars (CAD). After locking into a forward contract, you determine that the supplier is going to be late delivering the product by 30 days. You can enter an FX swap by exchanging CAD based on the current spot rate and agree to extend the transaction by 30 days prior to the contract expiring. This swap allows you to hedge against the risk of JPY appreciating against the CAD over the next three months, while also giving you the flexibility to change the payment date, ensuring you know the exact cost of your future payment. Currency swaps involve two simultaneous transactions: exchanging a specified amount of one currency for another at a spot rate and reversing the exchange rate at a predetermined future date and rate. This tool helps in hedging against exposure to currency fluctuations and securing short-term funding in a different currency without impacting the balance sheet. Currency Options A currency option, also known as an FX option, is a financial instrument that gives the holder the right, but not the obligation to buy or sell money denominated in one currency into another currency at a pre-agreed exchange rate, or strike price, within a specified period. For instance, an Australian company that expects to pay $1 million in New Zealand dollars NZD in six months for goods from New Zealand, is concerned the Australian dollar (AUD) might weaken against the New Zealand dollar (NZD), increasing costs. The treasurer may buy an FX option to lock in a current exchange rate of 1.10 AUD/NZD for $500,000 NZD. If in six months, the AUD/NZD rate worsens to 1.20, the company can exercise the option, saving money by paying at the locked-in rate. If the AUD strengthens, say to 1.05, they can let the option expire, paying at the better market rate, with the option’s premium as the only cost for this price protection. Currency Futures Contracts FX futures contracts entail standardized agreements to buy or sell a currency at a predetermined price on a specified future date These contracts specify the currency amount, exchange rate, and settlement date. As all contract…
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Excel for the Modern Corporate Treasury
This article is written by Automation Boutique Excel has been a trusted tool for treasury and finance professionals for decades. Most of the treasurers we speak to today still indicate that Excel is a vital tool in their treasury operations. It is widely used for key processes, like cash flow forecasting, cash management, risk management and reporting. While Excel is familiar and extremely flexible, improvements to existing Excel-based processes are urgently needed to also make it a successful tool for the coming years. The good news is that Excel contains many hidden gems that allow you to develop models that are automated, robust, and easily auditable. The popular narrative has been to transition away from Excel in corporate treasury, mainly due to its potential for errors and the complexities of managing large files. At first glance, this is understandable, because most Excel-based processes have significant problems: But here’s the thing: a lot of treasurers (even those who are using a Treasury Management System (TMS)) still use Excel for important tasks. Why do they do this? First, a lot of treasurers have found out that there isn’t a single TMS that does everything they need. So, they still need Excel for some tasks. Second, some companies don’t have the budget or the need to buy a TMS. For them, Excel is the main tool they use for their treasury management. So, getting rid of Excel completely might not be the answer. Maybe there’s a better way to use Excel and still enjoy what it offers? How to Excel like a Pro Contrary to popular belief, we think Excel can remain a valuable tool for corporate treasury when used correctly. To maximize its potential, corporate treasurers should: 1. Use Automation Reduce manual tasks to make your work smoother and minimize errors. Options range from traditional methods like Visual Basic to newer tools like Power Query and Power Pivot. Optionally, RPA (Robotic Process Automation) can be added to automate the data refresh, data fetching, and action-taking based on the Excel outcome. 2. Ensure Traceability Knowing the journey your data has taken is crucial. Let’s break down why this matters: 3. Document the Excel-process It is important to document the purpose of the Excel file, the assumptions, how it was designed and how it should be used. Again, making use of Excel’s hidden tools can save a lot of effort for this often-neglected task. 4. Utilize Built-in Tools Over the years, Microsoft has improved Excel with powerful tools that can upgrade your existing Excel files: Power Query This tool lets you automatically gather and transform data from various sources, such as websites, databases, XML files, CSV files and other Excel sheets. You can perform actions like filtering and merging data with a few clicks. Importantly, Power Query remembers each step you take, which makes your process clear, robust, easy to replicate and to audit. Main advantages of Power Query include: Power Pivot This is another powerful tool within Excel that enhances your data analysis. Essentially, it allows you to manage and analyze large amounts of data, making your reports interactive and comprehensive. Main advantages of Power Pivot include: Looking Ahead with Excel Excel continues to be a key tool for corporate treasurers, but there’s a need to make it work better and more reliably. There are many features in Excel to help with this, but they are often hidden or forgotten. We at Automation Boutique can help you with reconstructing your Excel-based processes, making them automated, robust and easily auditable. Consider kicking things off with our “How to Excel” hands-on workshop. In this interactive and engaging session, we will work together to reconstruct your own Excel models, diving deep into Excel’s best practices and hidden gems. Don’t hesitate to contact us for further details. Happy Excel-ing! Also Read Join our Treasury Community Treasury Masterminds is a community of professionals working in treasury management or those interested in learning more about various topics related to treasury management, including cash management, foreign exchange management, and payments. To register and connect with Treasury professionals, click [HERE] or fill out the form below to get more information. Notice: JavaScript is required for this content.