Exposure to foreign exchange risk can affect any business, from small organisations to global enterprises. Changes in exchange rates can impact the value of your company’s assets and liabilities, and affect your overall profitability. This is likely to continue due to the current environment of considerable socio-economic uncertainty.
In order to mitigate against these effects, your organisation needs a well-managed FX risk management policy. Ultimately, your corporate FX risk management and hedging strategy should be appropriate for your business if it is to be sustainable and successful. As a starting point, we’ve outlined the different types of foreign exchange risk and the tools you can use to hedge these risks.
Types of Foreign Exchange Risk
The first step in the process is to identify the different types of FX exposure, all of which can be managed in a number of different ways.
At Clear Treasury, we can identify the source of the FX exposure, assess the materiality of the risk and propose strategies to mitigate the risk. We can price benchmark transactions to ensure that our clients receive the best possible price, alongside reviewing treasury policies to ensure that they are fit for purpose.
Primarily associated with imports and exports due to undertaking transactions in a currency other than your domestic currency, transaction risk is the risk of an exchange rate changing between the date of transaction and final settlement date – this can result in a gain or loss at the conversion stage.
A major threat if your organisation is conducting business in foreign markets, translation risk occurs when your company has any assets and liabilities denominated in a foreign currency which may, in turn, shift in value due to exchange rate changes.
Economic risk is caused by unexpected changes in exchange rates on your company’s future cash flows from foreign operations. Affecting both revenues and operating expenses, economic exposure can be difficult to manage through hedging strategies as it deals with unanticipated changes in FX rates.
Foreign Exchange Risk Management Strategies
There are a number of strategies, methods and tools available for hedging FX risks. Aside from internal strategies (like invoicing in your domestic currency or diversifying your supply chain in terms of location), we can advise on external hedging instruments to reduce the impact on your near term cash flow and longer term strategic decisions.
A spot fx contract is a binding contract to buy or sell an amount of foreign currency at the current market rate, for settlement in two business days’ time. Our counterparties are capable of making same day and next day value transactions and to third party (suppliers, clients etc.) if required.
Utilising a forward FX contract is one way to alleviate FX risks, securing an FX rate for future payments, thus securing profits. A forward contract is binding agreement between parties to sell one currency and buy another in a specified amount at a specified rate on a specified date in the future, either a fixed date or range of dates.
A currency option is a non-binding right to buy or sell a currency at an exercise price on a future date. The benefit of this over forward contracts is that you can allow the option to lapse to take advantage of any favourable movement in exchange rates, only exercising the currency option to protect against any adverse FX movement.
With over 50 years’ combined experience in the foreign exchange and payments markets, we are well positioned to help you manage your FX risks by preparing you with the necessary hedging documentation for organisations looking to make foreign exchange payments. Get in touch to find out more or learn more about our corporate finance consulting and treasury services.
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