Foreign Exchange Risk Management

By M. Isi Eromosele

Never before have global companies been so exposed to currency market volatility and the risks associated with it. As supply chains stretch around the globe, more companies are venturing farther into foreign markets, buying and selling goods in places long considered out of reach for all but the largest multinationals.

These international ventures often generate spectacular opportunities for business growth and financial prosperity, but they can also expose companies to significant and potentially damaging foreign exchange risk.

Currency Risk Management as Competitive Advantage

In an environment where currency fluctuations bear little discernible relationship to business fundamentals, profits can be wiped out in an instant and business models can be destroyed. The global landscape is littered with the remains of companies that failed to manage foreign exchange risk appropriately.

While most companies acknowledge the risks involved in doing business internationally, the positive impact that currency risk management can have on competitiveness is less often recognized.

The ability to effectively work across borders while avoiding currency-related losses can expand a company’s reach and increase profits substantially. A robust trading framework can provide a solid foundation for business success while positively differentiating a company from its competitors.

Primary Objectives

In order to achieve true effectiveness, a currency trading framework should be

designed with three goals in mind:

• Cash Flow Efficiency: Unpredictable and highly volatile cash flows can wreak havoc on resource allocation, dramatically lowering organizational efficiency. Increasing the predictive accuracy and accounting simplicity associated with the cycle of cash though a business can lower costs and substantially improve strategic planning efforts.
• Risk Mitigation: Vulnerability to swings in exchange rates can compromise profits and undermine a company’s ability to survive and succeed in new markets. Protecting the bottom line is absolutely crucial in ensuring that companies remain stable and sustainable in the long term.
• Opportunistic Market Entry: Exchange rate volatility represents both risk and opportunity. Few businesses are prepared to completely ignore the opportunities that can be captured when currencies move in a favorable direction and often leave themselves exposed to risk as a result. In order to survive changes in objectives and leadership, create a framework for executing trades at favorable levels, while keeping the organization protected against material risks.

Four Crucial Components of a Risk Management Strategy

With the global economy in upheaval, the only constant is change. Against this backdrop, building an effective risk management framework begins with envisioning a complete, integrated process.

A feedback loop must be created between business objectives and the tools and strategies used to achieve them, so that the organization continually adapts in response to evolving markets and circumstances. This cycle can be broken down into four essential components: 

Understand

Managing risk is impossible without having a clear picture of where exposures exist and the processes currently being used to manage them, if any.

Exposures: Broadly, there are three types of external currency risk that can materially

influence business performance:

• Transaction exposure is the simplest and most transparent – it is the gain or loss that can be generated when the exchange rate applied to cash flows changes. When costs or revenues are affected by currency fluctuations, the resulting unpredictability can damage many areas of the business.
• Translation exposures are more complex and occur when the value of a foreign asset or liability fluctuates due to exchange rate changes, resulting in a requirement to adjust balance sheet values. Translation vulnerabilities can create volatility on both the income and balance sheets.
• Structural exposures are those that may influence the very viability of a business model. If input costs rise in China over the years due to an appreciating exchange rate, does the operational structure collapse? If European sales become untenable, will the business survive?

Each of the above forms of risk can have substantial effects on earnings and sustainability. Traditionally, transaction exposures were the most commonly hedged, but the materiality of translation and economic vulnerabilities has increased in recent years as businesses have expanded internationally. The need for sophisticated monitoring and management techniques has grown exponentially.

Controls: After developing a picture of where exposures lie, it is important to look at the processes and strategies that are currently in place. Clarifying existing procedures for measuring and managing risk can help to identify areas of potential improvement. Mapping out the financial controls that are already in place is essential in determining where weaknesses may be present.

Objectives: If you don’t know where you’re going, you’re likely to wind up somewhere else. Interviewing internal and external stakeholders is often a good method for building an understanding of the risk tolerances and goals that should drive ongoing exposure management.

Lenders, investors and senior leadership often have differing perspectives, and these must be considered in order to avoid missteps. Of course, defining these objectives can be a highly subjective endeavor – performing a sensitivity analysis on earnings and quantifying these tolerances in terms of probabilities and percentages can be vital when building a robust policy framework.

Strategize

By ensuring that personnel are clearly accountable, processes are unambiguously defined, and strategic goals are well understood, a written policy helps to ensure that theory is translated into practice.

Formal policies vary widely in length and complexity, and the best are designed to scale up as the business itself evolves. While this process may sound time-consuming, a strong written document can be created relatively quickly and easily – particularly with the assistance of a foreign exchange specialist.

Ultimately, a risk policy simply needs to address four questions:

Why?

Defining the objectives of a currency risk management program can be tremendously beneficial for internal personnel as well as external stakeholders. The articulation of these goals in a written policy can be paired with ongoing education to ensure that all foreign exchange activities are aligned with primary business

objectives and risk tolerances.

When?

The more time that elapses between when an exposure is identified and when an offsetting hedge is placed, the greater the financial risk. Allowing subjectivity

into this process is one of the greatest sources of risk for the typical company.

Accordingly, specify the event that triggers analysis and establish the measurement process used to define and prioritize the exposure. Clear deadlines should be communicated, defining when exposures must be reported internally and when offsetting positions must be placed. Set out an exception process to be used when an issue occurs.

Who?

Without accountability, risk management theory never becomes practice. Clearly define functions and levels of responsibility within the organization while segregating duties so that appropriate financial controls can be maintained.

These roles and responsibilities should be assigned on a functional rather than individual basis so that procedures survive the inevitable personnel changes which so frequently derail otherwise sound policies.

Include personnel not normally considered financial decision-makers. Buyers, sales teams and executives often make decisions that carry foreign exchange implications. These decisions are a primary source of uncertainty, frustrating cash flow planning efforts and

often leading to substantial losses.

What?

Effectively managing currency risk requires using hedging tools in a disciplined and pragmatic manner. The strongest policies clearly name the set of financial tools that may be used by risk managers and describe the criteria to be used to judge their applicability in specific situations.

Applicable Tools

In general, currency risk can be managed in two ways: internally or via external financial hedges.

Offsetting exposures internally is unquestionably the most cost-efficient and effective method for lowering risk and should always be considered before resorting to external tools.

Netting an incoming cash flow against an outgoing one can sharply reduce the amount of currency exposed to exchange rate fluctuations without requiring entering into a financial instrument. Changing functional accounting currencies to better reflect cash flows is an excellent way to reduce the impact of foreign exchange on earnings.

Moving operations into a country where revenues are earned is often called natural hedging. Natural hedging can be an effective method for managing structural exposures, particularly when these operations support long-term strategic goals.

M. Isi Eromosele is the President | Chief Executive Officer | Executive Creative Director of Oseme Group - Oseme Creative | Oseme Consulting | Oseme Finance

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