Over 30% of global trade is done by Small and Medium Enterprises (SMEs) who often have limited experience in managing the foreign currency risks from their international activities. Without the knowledge, experience, or tools of their larger competitors, smaller businesses are often at a greater competitive disadvantage. This guide summarises best practices for FX risk management that SMEs should use to protect their businesses and regain a competitive edge.
This part of our guide covers several sections:
- What are FX risks? How to identify and assess them?
- What is risk tolerance?
- Basic currency risk-management strategies
- Introduction to HedgeFlows products
Foreign exchange risks explained
People have been exchanging currencies for almost as long as currencies have existed. Similar to any market, where goods can be purchased, the foreign exchange market is simply a generic term for a place where one currency can be bought or sold against another currency at a rate agreed between participants or according to rules.
For most currencies used in global trade, both of the currencies can be freely exchanged. In such cases, the exchange rate is driven by supply and demand and allowed to fluctuate freely. These currency exchange fluctuations are driven by factors ranging from monetary policies of the relevant countries to foreign investors’ appetite or trade imbalances between countries to name a few. A range of FX market participants contributes to the supply and demand of a currency and the transactions they conduct ultimately determine foreign exchange rates. As these rates fluctuate, the value of the future foreign currency payments paid or received changes according to the home currency of the buyer or seller, and with these fluctuations comes currency exposures and risks to a company's profits.
It starts with Foreign Currency exposures
A business's first encounter with foreign exchange is usually when they start buying or selling goods internationally. If such transactions are paid in full at the time of the deal, the foreign currency conversion is a straight-forward process; in these cases, there are many foreign currency payment solutions available to help businesses.
However much B2B cross-border trade involves transactions with a delay between the transaction or invoice date and payment due date. For example, delays can arise from shipping, where freight takes weeks to arrive at the destination where the goods change ownership. Other delays arise from an Open Account or other credit arrangements, where buyers pay their suppliers with an agreed delay, or from custom orders that involve a lead time to allow for manufacture. Such complexities frequently introduce the risk whereby the value that the company expects to pay or receive might change unfavorably for them.
If you are reading this then you are most likely aware of currency risks, but if you find yourself wondering whether you have currency risks or how big they are, it helps to break it down into separate concepts, namely currency exposure, currency risks, and risk tolerances. This approach may help to shed light on otherwise overlooked areas and eliminate possible biases regarding currency risks.
Put simply, a business has currency exposure if its financial results or cash flows are sensitive to currency fluctuations. This is separate and independent from assessing the probabilities of FX rates going up or down or being at a certain level at a given future time. The currency exposure of a business can also have both positive and negative connotations; its margins might be either higher or lower depending on the future exchange rate.
How to identify your currency exposure?
- Do you pay or receive foreign currency on your cross-border sales or supply contracts that involve a delay between invoicing and payment?
- Are you selling goods or services to customers abroad and can you change your price in the foreign currency without impacting your customer demand?
- Do your customers sometimes cancel their orders after contracts have been agreed or invoices have been sent or received? If payment has been made in such cases do you have to reimburse them in foreign currency?
- Do you pay international suppliers for goods or services; if so what could you do if their prices change due to currency rates in coming quarters?
- Do you have to commit to manufacturing costs or other costs for raw materials, goods or services in one currency before you can find buyers in another currency?
- Does your business own or owe any longer-term foreign currency, for example, foreign currency loans or foreign investments?
The above will help answer three key questions:
- Which currencies are your business sensitive to?
- How big are exposures (per transaction or per period)?
- What time period are you exposed for?
More can be found in our FX risk management guide:
FX risks and tolerances, FX forwards explained, FX Options, and introduction to HedgeFlows products