Recent fluctuations in global currencies have brought exchange-rate risk back to the agenda for businesses working with customers, suppliers and production in different currencies. Many businesses are subject to currency risks, whether they realise it or not.
This summer we have seen huge fluctuations among many currencies. Escalation of the global trade war has caused havoc on currency markets. The US dollar thrives on global risk aversion while many emerging markets currencies have felt the pain. At one point the Turkish lira went into a free fall – down by almost 20% versus the US dollar in just one day. Among the other casualties have been the Russian rouble and the Argentine peso.
They key learning is that if you run a business that earns revenues from abroad or have costs in other countries; you most likely have exposure to currency risk. Political events, out of your control could impact your revenues and increase your costs.
So how big is the problem with managing currency risks?
In a survey of 200 chief financial officers (CFOs) and nearly 300 treasurers conducted by HSBC and FT Remark, 70% of CFOs said that their company suffered reduced earnings in the last two years due to avoidable, unhedged FX risk, 58% of CFOs in larger businesses said that FX risk management is one of the two risks that currently occupy the largest proportion of their time, while 51% said that FX is the risk that their organisation is least well-placed to deal with.
On the flip side, managing your currency risks can bring your business benefits:
- Protection for your cash flow and profit margins
- Improved financial forecasting & budgeting
- Better understanding of how fluctuations in currencies impact your balance sheet
- Increased borrowing capacity
When currency exchange rates fluctuate, businesses rush to prevent potential losses. What currency risks should they hedge—and how?
5 steps to manage your business’s currency risk
Understanding where and how currency fluctuations affect a company’s cash flows is not straightforward. Many different factors—from macroeconomic trends to competitive behaviour within market segments—determine how currency rates affect a business’s cash flows.
1. Review your operating cycle
Review your business’ operating cycle to learn where FX risk exists. This will help you determine your profit margins sensitivity to currency fluctuations.
2. Measure and manage your exposure to currency risk
This should include the risk exposure before a deal, purchase or transaction is agreed and the actual risk that exists after a completed transaction. When you have a sense of pre- and post-transaction risk, you will be able to decide on your needed level of hedging.
Transaction risks are the simplest currency risk to measure and manage. These occur because of timing differences between a contractual commitment and actual cash flows. For example, if a business manufactures a product in China and sells it in Denmark for a price set in Danish krona and the payment terms allow the buyer to pay days or weeks later, the business’s cash flow will be exposed by currency fluctuations while it waits for settlement. Transaction risks can be hedged with financial instruments, including currency futures, swaps, or options.
3. Hedge your currency risk
Hedging means that you use financial instruments, such as currency or FX forwards to lock in the currency rate so that it remains the same over a specified period of time.
4. Create an FX policy and stick to it
An effective FX policy begins with a clear corporate strategy and clarity on corporate objectives. The policy should identify key metrics– be it cash flow, EBITDA, asset values, debt- and interest coverage ratios. In addition, the policy should include some form of measurement of your business’s risk tolerance. That risk tolerance could be expressed as a target default probability, cash flow at risk, or simply a target coverage ratio or credit rating.
5. Accept that you have unique currency flows
Every business is unique and it is reflected in your currency flows, but also in the structure of your assets and liabilities. It is key to understand that currency fluctuations may have an impact and the decision to hedge or not, is not as simple as to roll the dice. For business that rely on foreign manufactures or suppliers, Nordea Markets has developed a specific service.
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