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Classically, FX risks can be categorised as 'transaction', 'translation' or 'economic'. Global foreign exchange market turnover was 20% higher in April 2010 than in April 2007, with average daily turnover of $4.0 trillion compared to $3.3 trillion. Roughly a sixth of that activity comes from non-financial companies. If exchange rates did not move, the bulk of that activity would be pointless and FX risk management would be irrelevant.
Some currencies really do not move; consider the Bermudian dollar, fixed at par to the US dollar, and the Bulgarian lev, pegged to the Deutsche Mark at one-for-one in the early nineties and at 1.95583 to the euro since the Mark joined the single currency. But most currencies are not fixed and none of the major currencies are pegged to one another. So they move. Strong selling interest pushes them lower just as excess demand takes them upwards. Witness the speedy decline of the pound after a failing Northern Rock decimated confidence; see how nervousness in the financial system took the yen higher as the world bought it for its perceived safe-haven qualities.
In theory, the bigger the currency, the less volatile its price. The US dollar can absorb huge inflows and outflows in a way the Australian dollar could never presume to achieve. But it still moves. And any business that might make or lose money as a result of that movement is at risk.
Currency risk can take several forms. At its simplest, it represents the difference between the price of a foreign currency now and the price when you first recognised the need to buy it. That difference will mean an opportunity profit or loss if the risk has been left unmanaged. At the other end of the spectrum is the risk that a domestic producer with a domestic customer base could be undercut by foreign suppliers if their currency were to weaken. Although the international firm has no overt exposure to FX risk it faces the economic risk of losing out to international competition as a result of exchange rate movement.
For any company with international activities or ambitions, the first step towards effective FX risk management is to ask whether risks might actually exist. With that formality out of the way it requires no great conceptual leap to make an assessment of the risk. Call it an 'exposure analysis' or something, to avoid the negative connotations of health-and-safety 'risk assessments'. The analysis should take into account:
- Payments to foreign suppliers (regular and occasional)
- Receipts from foreign customers
- Foreign purchases or sales, even if they are currently sterling-denominated
- Existing and projected foreign investments and subsidiaries
- Foreign currency loans and borrowings
- Business plans likely to involve overseas activity, including tenders
- The power of employees to commit the firm to FX transactions
Classically, FX risks can be categorised as 'transaction', 'translation' or 'economic'.
'Translation' risk exists where a long-term foreign-currency asset or liability must be revalued for accounting purposes. Translation exposure, because it usually relates to long term assets and liabilities, is something that only about 50% of companies actively manage. One of the most effective ways to manage this exposure would be to match the overseas assets with foreign currency loans.
An example of direct impact of 'economic', or commercial risk can be taken from when Kodak came a cropper in the 1980s as a weak yen allowed Fuji to undercut the pricing of Kodak film in its domestic market. Monsanto lost overseas sales at the same time, for the same reason, when it found that its dollar-denominated price list had lost its attraction to customers.
'Transaction' risk is similarly persistent. By using forward FX transactions, it is entirely possible to hedge against unfavourable currency moves. To cover all your exposure though is a 100% bet that the value of the currency would go against you. You immediately forfeit the opportunity to participate if the market moves in your favour.
For exactly these reasons many companies are now using more sophisticated methods to hedge their currency exposure. There are several currency option structures available today. Structured in the right way, these options could protect you fully against adverse market movements and allow for participation if the rate moves in your favour.
For companies with exposure to international markets, fluctuating exchange rates could have a significant impact on profits, cash flows and, ultimately, shareholder value. By actively managing these risks one installs confidence amongst senior management, shareholders and lenders alike. Employing a suitable hedging strategy not only protects businesses from financial shocks, it also provides clearer sight of future cash flows and contributes to a more transparent budgeting process.
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