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FX risk – the basics

In the first of three articles on foreign exchange risk, we outline the different types of FX risk exposure faced by companies and discuss how these exposures can be avoided or reduced through internal business practices.

Foreign exchange (FX) risk is the risk that changes in exchange rates may impact on a company’s profitability and/or the value of its assets and liabilities. By addressing FX risk, a treasurer needs to determine the nature and extent of the FX risk exposures as well as the strategies and tools that are available to manage the identified exposures.

Identifying FX risk exposure

The first stage of FX risk management involves the identification of items and amounts that are exposed to FX risk. Assets, liabilities, profits or expected cash flow streams can all be exposed to FX risk if changes in the exchange rate would alter their home currency value.

Types of FX risk exposure

There are essentially three main types of foreign currency exposure: transaction exposure, translation exposure and economic exposure. Each of these exposure types can be managed in different ways. Much of the complexity of foreign exchange risk management derives from the interaction between these different types of FX exposure and the combination of FX risk management strategies and tools required to manage them.

Transaction exposure

This type of exposure arises when a company undertakes transactions in a currency other than its domestic currency. It is usually the result of international or domestic trade in foreign currency and is the simplest form of FX exposure. A company is exposed to transaction exposure when it makes or receives payments in a foreign currency.

For example, when a company purchases goods that are quoted in foreign currency, it is exposed to the risk that its home currency will depreciate in value against the foreign currency, leading to a rise in the price it has to pay for the goods in terms of its domestic currency.

If the same company is selling in foreign currency it is exposed to the opposite risk – that its home currency value will appreciate. The company would then receive the quoted price on its goods in foreign currency but the equivalent value in its home currency would be less than anticipated.

Transaction exposure may also affect any other transactions, for example funding that has been arranged in a foreign currency. This includes the risk of increased debt obligations as interest and in principal have to be repaid in foreign currency.

Other examples of transaction exposure can include any quotes (eg tenders) in foreign currency or any contractual obligations based on inputs linked to foreign currency, such as the oil price which is quoted in US dollars.

Translation exposure

Translation or accounting exposure arises when a company has assets and liabilities denominated in a currency other than its reporting currency.

Accounting regulations may require that the foreign currency value of items such as shareholdings of subsidiaries or property holdings abroad must be converted into the company’s reporting currency in the preparation of consolidated accounts. Liabilities such as foreign currency loans also have to be converted at the exchange rate current at the reporting date. Any change in the exchange rate between the denominated and the reporting currency of these foreign currency assets and liabilities will therefore impact on the balance sheet of the company.

Under the International Accounting Standard IAS 21, translation gains and losses should be included in the group’s consolidated profit and loss account, which can lead to considerable fluctuations in reported corporate profits.

Translation exposure is therefore the possibility that the parent companys net worth and reported income will increase or decrease as a result of any translation gains or losses of foreign-currency denominated items in the consolidated financial statements.

Companies need to understand how this type of accounting risk may affect their balance sheet, bearing in mind that any negative effect on specific assets may be outweighed by beneficial effects of the exchange rate changes in other parts of the business.

Economic exposure

Economic exposure, also called operating exposure, is the risk that the firm’s present value of future operating cash flows is affected by changes in exchange rates. The concept of economic exposure is generally applied to a company’s expected future operating cash flows from sales in foreign currency and from foreign operations. In addition, some future cash flows that are denominated in the domestic currency may be exposed to competition from suppliers operating in other currencies. For example, a French company that mainly sells in its home market may be in competition with British companies active in selling into the same domestic French market. The euro/sterling exchange rate may impact on the expected cash flows, and ultimately the net present value of the French company, as the competitive position of its British competitors are strengthened or weakened by movements in the exchange rate.

The analysis of economic exposure would therefore assess the impact of changing exchange rates on a company’s operations and its competitive position.

Economic exposure affects revenues (domestic sales and exports) and operating expenses (cost of domestic inputs and imports). It has a long-term impact on the business and is reflected in the forecasting of cost and revenue streams whether these are in the context of finance, marketing, procurement or production planning.

Measuring FX risk exposure

Once the different types of FX risk exposure have been identified, the extent to which the company is exposed needs to be measured before an appropriate risk management strategy can be devised.

Managing transaction exposure requires that the company’s treasury collects all information on the volume and timing of the exposure. In order to obtain this information, the company may set up a system to log all transactions that give rise to transaction exposure. This can be based on monthly reports sent to the treasury by all entities detailing incoming payments and disbursements in foreign currency, the currency denomination and any existing covers (hedges). The consolidation of the data from all subsidiaries enables the group treasury to determine the group’s overall net transaction exposure and manage it in the most appropriate way.

Where economic and translation risk exposures are concerned, measuring FX risk exposure can prove difficult. Translation risk is typically measured by the exposure of foreign-denominated net assets (assets less liabilities) to potential exchange rate developments. Some firms use sensitivity analyses or value-at-risk (VaR) models, which define a maximum loss for a given exposure over a specified time period with a certain degree of confidence (eg 95%).

Economic exposure analysis involves measuring the potential impact of an exchange rate deviation from a budget or benchmark rate used to forecast revenue streams and costs over a given time period. The currency effects on the various cash flows have to be netted over the company’s operations and markets. The more diversified a company is, the more these effects should cancel each other out and the net exposure may be comparatively small. However, companies that have invested heavily in one or two key foreign markets are typically exposed to more significant economic FX risk.

Managing FX risk

Based on the determined level of risk exposure, the company will need to decide how to manage its FX risk. Any company effectively has three options when dealing with FX risk exposure:

  1. Not to the hedge the exposure – the company will simply continue to monitor the risk exposure and potentially adopt a different strategy in the future.

  2. Manage the exposure internally through business practices.

  3. Hedge the exposure with financial instruments.

By hedging a particular transaction a company establishes a currency position, which will offset a foreign exchange gain or loss of the exposed transaction by an equivalent loss or gain of the foreign currency hedge. As a result, hedging locks in a domestic currency value for the exposure, irrespective of any changes in the exchange rate.

To hedge or not to hedge?

While there has been some debate in academic circles about the general necessity of hedging FX risk, in practice corporate treasurers will adopt a range of FX risk management strategies depending on the size of the company, the ability to forecast exchange rates and the type of FX exposures.

As a result, different companies will have different approaches to managing FX exposures. Some firms may be willing to accept a certain level of FX risk in keeping with the company’s risk appetite as agreed by the management board and defined in the corporate risk management policy. This policy will also specify the extent to which the use of derivatives to manage risk exposures is permissible. Under IFRS, the accounting impact of potential hedging transactions will also be an important consideration when deciding on how to manage foreign exchange risk.

Other companies will attempt to hedge as much of the FX risk exposures as possible at an acceptable cost.

Companies may also choose between active and passive FX risk management styles. Active risk management would in this context require resources and expertise in order to take a view on likely foreign exchange movements, aiming to generate FX gains to offset hedging costs. A passive FX risk management style, in contrast, requires fewer resources and has the primary objective of limiting the risk related to specific identified exposures, without having to forecast future exchange rate changes.

Most companies will predominantly target transaction exposures and are less inclined to hedge translation or economic exposures. This is largely because translation and economic risks are more difficult to quantify. Translation risk is also often less of a priority as it affects a company’s balance sheet rather than its income statement.

Some academic studies have suggested that the impact of translation exposure on the company’s share price is relatively low and that the attempt to hedge translation exposure can give rise to additional transaction exposures, making it difficult to manage both types of exposure at the same time. It has also been argued that the management of translation exposure is a question of corporate communications and investor relations rather than financial risk management.

Still, many companies decide, due to their specific risk exposure, to hedge translation risks in order to avoid the impact of sudden exchange rate changes on the valuation of subsidiaries, the debt structure and international investments.

Economic exposure is typically managed as a residual risk.

Internal FX exposure management

Before a hedging decision is made, the management of FX risks will first make use of all those financial management techniques available to a company that aim to prevent or reduce FX risk exposures. These techniques can include netting, matching, leading/lagging, pricing decisions and asset/liability management.

Netting

Netting involves the consolidated settlement of receivables, payables and debt among associated companies. These intra-group cash flows between the subsidiaries of a company are netted out in order to minimise the amount of foreign currency exposure and the need for FX trades.

For example, a UK subsidiary owes a Spanish subsidiary the USD equivalent of €4m and in return expects receivables of $2m. Both amounts are netted out and only one payment of $2m has to be effected instead of two payments of a total of $6m, resulting in savings in terms of transfer and exchange costs.

Matching

Matching involves the pairing of foreign currency inflows and outflows in terms of timing and value. This can apply to both intra-group and third-party transactions. The need to obtain currency in the foreign exchange market is reduced by timing currency inflows and outflows. In practice this is difficult to achieve as the timing of third-party receipts is often uncertain and much depends on the quality of information with regard to payables and receivables flows.

Leading and lagging

Leading and lagging are effectively adjustments made to credit terms between companies. Leading, the payment of an obligation in advance of the due date, and lagging, the delayed payment beyond its due date, are techniques that can be used to benefit from expected exchange rate changes.

For example, a company that has to pay a foreign currency obligation in three months time and expects that its home currency will have depreciated by then could opt to pay in advance. Alternatively, if the home currency is expected to appreciate, the company could benefit by paying later. As these techniques are mostly not mutually beneficial they are mainly used between associated companies, leaving group treasury to decide on the most appropriate timing of intra-group settlements for the group as a whole.

Pricing policy

In order to avoid foreign exchange risk, companies could always invoice in their domestic currency or in a currency in which they incur costs. However, when buyers have a different preference the pricing policy will often reflect this and customers may be invoiced in their desired currency to support sales. It can also be argued that payments will be made faster if customers can pay in their desired currency, ie home currency. The effects of the pricing policy in terms of FX risk exposure must therefore be weighed against its impact on sales and DSO.

Operation hedging

Alternatively, companies can attempt to net their exposure by shifting their cost base, for example payments to suppliers or production costs, to currencies in which they receive income. Companies which have the ability to shift sources of supply, product-lines or production facilities can therefore reduce their FX risk exposure. However, generally these types of changes to the operating profile are very costly and any adaptation in response to FX risk exposure will therefore only be considered when all other less costly measures have been exhausted.

Asset and liability management

Asset and liability management can be used to manage cash flow, balance sheet or income statement exposure. A company with an aggressive strategy may aim to maximise profits in the foreign exchange market by attempting to increase both cash flows and assets in currencies that are expected to appreciate and cash outflows in currencies that are anticipated to depreciate. This could entail the increase of exposed cash, debtors and receivables in strong currencies as well as the increase of borrowings and trade creditors in weak currencies. At the same time, the company will aim to reduce existing borrowings and trade creditors in strong currencies as well as cash, debtors and loans receivable in weak currencies.

A more defensive approach, in contrast, would simply aim to match cash inflows and outflows according to their currency of denomination, without taking into consideration the strength of the currencies.

When all these internal risk management techniques have been explored, a decision can be made on whether and how to hedge the remaining risk exposure with financial instruments such as forwards, swaps or options.