3 Step Plan to Mitigate FX Risks
This article is a contribution from one of our content partners, Bound Efective FX risk management. The big corporations have long been perfecting it, and yet few smaller tech companies do any sort of FX risk management, even though they are suffering the most from it! Why? Because tech companies have more obstacles in the way. Fortunately for you, one of the greatest hurdles is simply knowing about the problem, and if you’ve clicked on this article, chances are you recognise FX risk as something that needs to be dealt with. So, what can you do about it? There are some tools and techniques available to tech businesses that allow them to take control of FX risks themselves. Here are 3 practical steps worth considering to kickstart your FX strategy: 1. Assess risk exposure As a small or mid-sized company decision-maker, is it worth your while to expose your firm to foreign exchange risk? That’s a fair question to ask. If you’re only making smaller payments overseas, the need for a substantial FX risk program is relatively low. Yet if the level of foreign exchange transaction activity can impact your bottom line, you should consider a strong risk and volatility FX campaign. Our volatility simulator might be able to help you answer that question – you can assess potential risk based on the business’s revenue and expenses. This article could also help. 2. Set your sights a) Low risk? Get the best rates So you’ve decided that your currency risk exposure is low? In that case, a substantial FX program may not be necessary, but you still want to make sure you’re getting the best exchange rates possible for your business’s overseas transactions. With an abundance of options for currency conversion – banks, online platforms, brokers, fintechs – it can feel like trying to boil the ocean to choose the right one. To cut through the noise, we’ve got articles that can help you decide a whole lot faster. b) High risk? Manage it So you’ve decided that your currency risk exposure is significant? Well, it might be wise to employ a hedging strategy to minimise this risk sooner rather than later. Hedging can seem daunting and complicated because there is a lot of misleading information out there, but in reality, it is as complicated as you make it. To keep it simple, start by figuring out what your FX risks are, and the resources you have to dedicate to FX management. Pinpoint and prioritise risks that can be dealt with through hedging. Then you can move on to step 3. 3. Get aggressive with hedging You’ve understood your risks and internal resources, and want to hedge. But what hedging strategies are out there? Let’s very briefly cover the bases. Internal hedging is doing it in-house, using methods like risk sharing, price variation, matching, or simply sticking solely with the domestic currency. Each of these come with their own risks and challenges. External hedging is a very popular option, seeking external help from a third party. Banks, forex brokers, and specialised tech firms are the options here. They allow you to hedge via financial instruments like forward contracts, options, and futures can be extremely effective, albeit complicated. Many treasurers look to automate these hedging strategies for the easiest management. There’s a lot to learn about hedging, so take your time choosing the best strategy – you should know what you’re doing and why you’re doing it. Once you’ve implemented your hedging strategy, be sure to keep on top of it, stay educated, and make adjustments when necessary. That’s the 3 step plan, good luck! Recommended Reading 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. Notice: JavaScript is required for this content.
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Balance Sheet Hedging: what many companies get wrong
This article is written by Kantox In the context of the firm’s commercial exposure, FX gains and losses reflect fluctuations in exchange rates during the time lapse between the moment an FX-denominated transaction is recognised as receivable or payable in the firm’s balance sheet, and the settlement of the corresponding transaction. To remove the impact of FX gains and losses from the P/L, firms can implement balance sheet hedging programs. The most common setups include: In this and in the following blog, we provide an answer to the following questions: How do firms run their standalone balance sheet FX hedging programs? Do they follow a time-based approach, or do they attempt to hedge every single piece of exposure? Finally: Is there a more convenient, middle-ground approach that makes a better use of fx-automation solutions? The ECB exchange rate When a firm recognises an FX-denominated transaction as a balance sheet item, the basic accounting principle is clear: the receivable/payable must be booked at the spot rate of the day. For European companies, this often means the ‘reference rate’, also known as ‘ECB reference rate’. What is the ECB reference rate? The reference rate is published daily by the European Central Bank (ECB) on its website at around 16:00 CET. Its levels are set after consultation between central banks across Europe, reflecting market conditions around 14:10 on weekdays. As the ECB is careful to remark, reference rates are for information purposes only, i.e., not for transaction purposes. How to remove FX gains and losses When we consider the FX risk map in the context of balance sheet exposure, the ‘pricing moment’ and the ‘firm commitment moment’ are already in the past. What matters is the exposure that arises from the recognition of the balance sheet item until the settlement of the corresponding transaction. To manage this exposure, firms usually hedge with forward contracts. Some companies may choose to partially or completely hedge that exposure. We know, for example, that the German global health care company Merck hedges balance sheet items in full, a practice that started in the 1990s as the firm sought a way to lower the cost of equity capital. As balance sheet items are revalued alongside the hedging instrument, changes in opposite directions offset each other. If the currency of a receivable appreciates against the firm’s functional currency —displaying an FX gain—, the reverse happens to the forward contract, as the foreign currency was sold, by definition, at a less favourable rate. Removing FX gains and losses: things to consider Pitfalls of removing FX gains and losses: hedging at set dates The most common method used by companies as they seek to remove the impact of FX gains and losses is to take currency hedges at a given, arbitrarily set date. This method consists in pulling, out of the ERP, accumulated pieces of exposure —i.e., FX-denominated balance sheet items— and then taking the corresponding hedge with a forward contract. The process is then repeated at one point in the month, usually at the end of the month. The main pitfall of this procedure is easy enough to figure out: there is still a time lapse between the moment the exposure is captured and the corresponding risk mitigation exercise. This results in FX gains and losses, undermining the main goal of the program. Balance sheet hedging: Hedging at set dates We often see that, if the balance sheet item has a maturity of 90 days until settlement, then probably about 75 days are effectively hedged, which leaves —on average— two weeks with open FX risk. In some currencies, this can represent a material P/L impact — Antonio Rami, Kantox Chief Growth Officer Pitfalls of removing FX gains and losses: basic micro-hedging Some companies use a different method altogether. Instead of hedging accumulated positions at fixed dates, they attempt to hedge every single FX-denominated balance sheet item. Needless to say, this is quite a resource-intensive activity. Members of the finance team are constantly collecting and hedging the exposure. The cumbersome nature of this technique is a shortcoming because it may force the finance team to neglect some currency pairs. These could well turn out to create a P/L headache for the finance team. In the event, the goal of removing FX gains and losses would not be achieved. This approach also fails to reduce the cost of hedging in the presence of unfavourable forward points. A EUR-based or USD-based firm that immediately hedges a receivable in the Brazilian currency will leave a good deal of money on the table. This is because BRL trades at a 6% one-year forward discount to EUR on account of the gap between BRL and EUR interest rates. As we will see in our next blogs, there are better ways to deal with such forward discounts/premiums. Towards a market-based approach to removing FX gains and losses The two traditional approaches to removing the impact of FX gains and losses on the P/L present flaws. For different reasons, both of these approaches ultimately may fail to achieve the goals set by finance teams. On the one hand, hedging at arbitrarily set dates does not completely remove FX gains and losses due to the time lapse between the moment the exposure materialises and the risk mitigation exercise. On the other hand, attempting to hedge every single item in isolation is a resource-intensive activity that is only adapted to a situation of favourable interest rate differentials between currencies. 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.