Foreign Exchange and Risk Management

Companies have many risks associated with being in business but the key challenge is to ensure that all these risks are fully identified and understood. Companies need to mitigate such risks as they deem appropriate and currency risk is one risk which can be successfully managed via the treasury policy.

All Irish companies that are involved in any business transaction outside the Euro zone have a currency risk. Currency risk is the exposure to any changes in foreign exchange rates which may have positive or negative economic effects on any transaction.

Whilst the introduction of the Euro has certainly eliminated a large amount of foreign exchange exposure for many Irish companies, the growth of business transactions in countries outside the EU has ensured that fx risk remains an important issue.

Exchange rates movements can and historically have been significant, with daily movements of several percentage points regularly seen. Like all other business risks, it is important that companies make proactive decisions on how to manage/mitigate this risk. The economic impact of adverse movements in exchange rates can seriously question the viability of sourcing product abroad or indeed exporting into new markets.

Managing currency risk is not as straight forward as it may first appear. Hedging 100% of currency exposure may seem like the most logical solution but it should also be noted that if a company has all its currency hedged totally that it may be in an uncompetitive position should the foreign currency appreciate substantially.

Currency Risk falls into two broad categories:

1. Transaction Risk. – the risk that the Euro equivalent of receipts or payments in foreign currency will vary
between the time the contract is agreed and the actual payment date.

Example: if an exporter agrees a sale price of 100,000GBP with a client when the Euro/Gbp rate is at 0.6600 and when he receives the payment in Sterling the rate has moved to 0.7000. This movement of six percent results in a reduction of margin of 8,658 EUR on this contract.

2. Translation Risk – the risk that the Euro value of foreign assets or liabilities changes on the company balance sheet over time.

Example: if an exporter has an distribution centre in the UK which cost and was valued at 330,000 GBP is shown on his balance sheet at 500,000 EUR (rate 0.6600). If at the next balance sheet date the exchange rate has moved to 0.70 – the asset is now valued at 471,429EUR (ignoring depreciation costs).
There is a danger that it is very easy for companies to come to the following conclusions:

- that previous favourable movements in fx rates will continue into the future
- a view that fx rates will not go much further against the company
- because of wide trading margins the company can afford to risk losing some revenue due to adverse currency movements.

This in effect is the company choosing to speculate on the future movements of foreign exchange rates and such speculation is unlikely to form an integral part of the companies objectives or adhering to the treasury policy.

Currency Risk Management Policy

Companies need to establish their Currency Risk Management Policy and agree the balance that needs to be struck between protection, flexibility and cost. All company’s requirements in each of these areas are different and needs to be discussed whilst looking at all possible alternatives.

It is vital that companies implement their Currency Risk Management Policy which includes the following:

Identifying Risk: When business transactions are being priced/estimated it is important to be aware of the potential movements in fx rates over the life of a contract. It is also vital that when deals are agreed that decisions are made as to how risk will be managed.

Measuring Risk: The risk must be measured as accurately as possible to ensure that companies identify the economic significance of the fx exposure and establish budget parameters for these transactions.

Select Hedging Techniques: Once companies are aware of the actual risks involved it is necessary to look at the most appropriate hedging techniques available to match desired objectives. It is recommended to discuss these objectives with your bank to ensure any strategy proposed is suitable. It may be appropriate to leave some exposure un-hedged but this should be an actual risk management decision and not a default position.

Implement Hedging Technique: The company must ensure that it fully understands all possible outcomes of the strategy. The strategy should be implemented in full and confirmations of deals booked with the bank checked.