In last week’s article, we introduced the importance of FX risk management and discussed why businesses should pay more attention to their FX risk exposure. In this week’s article, we will dive deeper into specific methods that can be employed in service of managing FX risks.
For businesses, FX risk management refers to the practice of risk identification, risk measurement, risk control and other methods to prevent, avoid, transfer or eliminate risks in cross-border business operations. Such practices are vital in helping businesses to minimise losses and maximise benefits under certain conditions.
In the face of volatile FX markets, businesses usually employ a multitude of methods to reduce the adverse effects of exchange rate fluctuations on their business partners and themselves. These methods can be broadly classified into three categories:
1.Choosing an appropriate settlement currency
There are three main ways in which trade contracts are denominated when businesses engage in cross-border trade: 1) Denominated in the exporter’s domestic currency 2) Denominated in the importer’s domestic currency 3) Denominated in the traditional currency for the commodity (usually USD).
In traditional import and export trade, it is common practice for both parties to settle in USD. However, in recent years, a growing number of cross-border traders have begun settling in the importer’s domestic currencies (especially in unrestricted currencies such as EUR, GBP and JPY.)
2.Discretion in deciding when to make FX settlement
- FX Settlement
Businesses can undertake targeted measures to manage their FX flows to gain a better grasp of FX revenue and expenditure. For example, when a currency is expected to appreciate, businesses can decide to make payments more promptly and delay collection where possible. Conversely, if a currency is expected to depreciate, businesses can delay payments and collect payments more promptly.
- Buying Currency
Businesses can reduce the adverse effects of exchange rate fluctuations by purchasing FX in advance, although limited by official monetary policy. Businesses must provide the bank with relevant trade contract or foreign currency loan contract, the other party’s information, customs documents and other relevant qualification documents before they can apply to the bank to engage in FX-related business activities.
3.Hedging against riskier cash flows
Hedging refers to a practice that businesses employ to avoid FX risks, interest rates risks, as well as risks pertaining to commodity prices. By using one or more hedging instruments, a transaction activity whereby the fair value or the cash flow of the hedging instrument is subject to change is used to offset the partial or full change in fair value or cash flow of the object that is being hedged against. Hedging is the most effective and targeted exchange rate risk management measure for enterprises, which can help them mitigate the negative impact of exchange rate fluctuations.
On May 8, 2022 the exchange rate between USD and JPY was 130.68 JPY/USD. Under a trade contract, exporter B would receive a payment of 400 million yen on June 10. However, exporter B, concerned that the USD would continue to strengthen against the JPY, sought to settle the FX transaction one month in advance at a forward rate of 129.80. By selling 400 million JPY at a forward rate of 129.80 JPY/USD, he was able to purchase 3,081,664.09 USD.
The settlement date of the transaction is June 10 2022, when exporter B is expected to pay 400 million JPY to the bank and the bank will pay 3,081,664.09 USD to the company. Following this forward FX transaction, company B can sell yen to the bank at the agreed upon rate of 129.80 JPY/USD, regardless of changes in the international FX market.
On the other hand, without a forward deal, if exporter B waits until the day it receives payment i.e. June 10, he would have had to adhere to the prevailing rate on the FX market. More specifically, when the dollar strengthened, and the JPY/USD exchange rate was 134.39 on June 10, exporter B would have had to sell 400 million JPY at 134.39 JPY/USD to receive 2,976,307.84 USD in return. In comparison to making a forward FX deal, the company would have made 105,356.25 USD in FX losses alone.
From the above scenario, we can see that by making proper use of forward foreign exchange instruments, importers or exporters can lock in costs and better avoid potential losses from exchange rate fluctuations.
Key Benefits of Hedging
1. Hedging helps organisations:
a. Formulate short and medium-term financial budgets and financing decisions.
b. Reduce fluctuations in annual financial indictors (impact of smooth risks on income and costs).
c. Temporarily mitigate market volatility
2. Hedging has advantages over the other two risk management measures
a. More flexible than the other methods and different financial products can be selected according to risk tolerance and the nature of business operations.
b. Greater ease of overall planning and transaction management to bring cash flow in line with company expectations
c. Longer coverage and better stability
d. Avoids the risk of currency settlement and policy changes, helping enterprises lock-in costs and mitigate uncertainty.
Through hedging, businesses exposed to FX risks can achieve the following results:
1.Balance of Payments
Through hedging businesses can mitigate instances of loss in revenue and rise in cost due to FX fluctuations, helping to smooth out income and expenditure. It can also enable businesses to stabilise their sales and purchase prices amid adverse exchange rate fluctuations, to increase the stability of business revenue and expenditure to ensure smooth business operations.
Export Businesses: Stabilise foreign denominated receivables, to ensure guaranteed domestic currency denominated income.
Import Businesses: Stabilise foreign denominated payables, to ensure guaranteed foreign currency denominated purchasing power.
2.Assets and Liabilities
Through hedging, businesses can also reduce the impact of financial difficulties and improve debt repayment capabilities. By reducing fluctuations in cashflow, businesses can reduce the probability and consequent impact of financial problems.
For businesses holding dollar denominated liabilities: With the possibility of the fed raising interest rates, a stronger dollar will increase the price of USD bond repayment for those whose domestic currency is not USD. For example, a UK company with USD bonds would have to sell GBP to make their USD bond payments. However, if the fed funds rate increases, the USD would strengthen against the GBP and increase FX risk exposure for the UK firm. In this case, the firm would benefit from striking a prior GBP/USD forward FX deal to hedge against a strengthening USD.
For businesses holding current assets in USD: Increased returns on current assets in USD can reduce FX losses resulting from fluctuations in the exchange rate between your domestic currency and the USD, which can reduce your cash value.
As such, it is important to understand the different types of FX risk management methods in order to better minimise losses to changes in the FX market. In next week’s article, we take a more pragmatic approach at how businesses can implement steps to employ these FX risk management methods to better meet their own business needs. If you are interested to learn more, follow us on LinkedIn to keep up to date on new articles or you can you can visit our website to see how SUNRATE can help your business with your FX needs.