The Minefield of Managing Foreign Exchange Risk
August 13, 2021
Exchange rate fluctuations can make a nonsense of even the best or the most carefully planned piece of business, whether it is an overseas sale or procurement decision. Income flows from foreign subsidiaries or joint ventures can also be affected, or the carrying value of those investments.
The most common and simplest type of foreign exchange risk is transaction exposure, caused by an actual business transaction taking place in a foreign currency. It could be down to a currency rate movement between when a sale to a customer is made and when your invoice is paid or, in the case of a purchase, between placing the purchase order and paying the supplier’s invoice. It might also occur between when a foreign subsidiary declares a dividend and remits the funds to the parent company.
There can be translation exposure from the conversion of the financial statements of a foreign subsidiary from its local currency into the reporting currency of the parent for its consolidated accounts. A strong trading performance in local currency terms can be made to look much less positive by adverse exchange movements. Investments denominated in foreign currency can need significant restatement if that currency has moved against sterling since it was made, as can foreign currency cash balances or borrowings.
This final type of foreign exchange exposure is caused by the effect of unexpected and unavoidable currency fluctuations on a company’s future cash flows and market value. It is inherently longer term in nature. This type of exposure can impact on strategic decisions, such as where to invest in manufacturing capacity or what jurisdictions in which to concentrate marketing.
To Mitigate or Take the Risk?
The first question to ask is whether to bother attempting to mitigate these risks at all. It may be that a company accepts the risk of currency movement as a cost of doing business and is prepared to deal with the potential earnings volatility. It may have sufficiently high profit margins to provide a buffer against exchange rate volatility or have such a strong brand/competitive position that it can raise sales prices or negotiate better purchase deals to offset adverse movements. It may be able to insist on doing business overseas in sterling, rather than the local currency.
Building Protection into Commercial Relationships and Contracts
With some major projects or long-term contracts involving a foreign currency element, fixing exchange rates and prices at the outset may jeopardise profitability as and when currency rates move. It may be possible to build clauses into the contract that allow revenue to be recouped in the event that exchange rates deviate by more than an agreed amount. This will obviously pass some or all of the foreign exchange risk to the customer or supplier and will need to be negotiated just like any other contract clause.
Adopting this strategy means that the legal language in the contract must be strong and the indices against which the exchange rates are measured have to be stated very clearly. Where these clauses are used, they must be reviewed regularly review to ensure that once an exchange rate clause is triggered the necessary process to recoup the loss is actioned.
This strategy can lead to tough commercial discussions with the customers when clauses are triggered and it may sometimes be wiser not to enforce such clauses to protect a client relationship, especially if the timing coincides with the start of negotiations on a new contract or an extension.
Natural Currency Hedging
This can be achieved where a business is able to match revenues and costs in foreign currencies so that its net exposure is minimised or eliminated. This is most likely to be effective where there are activities across many countries, particularly in common currency areas like Europe or South America. The downside is the administrative burden of tracking net exposures and maintaining multi-currency financial records.
Typical examples are forward exchange contracts and currency options, which can be used to introduce certainty into transactions by fixing rates. They will tend to protect downside risk but limit upside windfall currency gains. They come in many shapes, sometimes with considerable complexity. They can come spectacularly unstuck, usually when the underlying assumptions for a particular hedging strategy are changed by events or based on poor commercial judgement.
Getting Expert Advice and Execution
Anyone who thinks they can outguess foreign exchange markets, or always win their currency bets is destined for a life of constant disappointment. Local or geo-politics move rates, as do natural or man-made disasters – never mind a global pandemic with its consequential, extreme supply chain disruption. The best that can be hoped for is risk management and mitigation; for most businesses, that means having access to professional expertise and deploying an appropriate strategy.
This can be available in-house where the volume and scale of foreign currency transactions justify the fixed cost. Alternatively, using an outside foreign exchange manager with a proven track record can pay handsome dividends. This is one commercial area where deploying an enthusiastic amateur is likely to wreak the maximum financial damage.
Details of our expertise and experience in this foreign exchange risk management can be found here.
If your business is affected by foreign currency risk, we and our foreign currency experts are here to help you identify the issues, work with you to design appropriate strategies and assist with their implementation.