By Wichard Cilliers, Director & Head of Market Risk Management
Introduction
Exchange rate fluctuations are a common aspect of the global economy, affecting from small importers or exporters to individuals investing overseas to multinational corporations operating across multiple countries. The impact of these fluctuations can be significant, and getting it wrong can have substantial financial consequences. This is why foreign exchange risk management (or forex risk management) is so crucial.
South Africa’s rand is traded in large volumes globally and is seen as a proxy for emerging market investment. It makes the currency highly exposed to external shocks and, thus, highly volatile. According to the IMF, the rand is one of the most volatile currencies globally compared to advanced economies and emerging market peers. Only the Russian rouble and Argentinian peso have been more volatile in the last decade.
The result is that very few businesses can successfully operate without an FX Hedging policy and risk framework. The “brain drain”, which is also fairly unique to South Africa, makes finding and keeping experienced resources much more difficult, and the cost is out of the reach of many businesses. Unfortunately, many companies today still fail to properly mitigate foreign exchange risk and suffer the consequences.
At TreasuryONE, we are the FX risk advisors to small, medium, and large enterprises. Our solutions are scalable and built around client needs. With 24 years experience, more than R300bn FX traded in 2023 we know how to keep a cool head when the market is volatile and how to extract value for clients and protect profit margins. This blog aims to provide a simple guide to understanding and managing currency risk, drawing on personal experiences and practical examples. I hope you find it useful.
Types of Foreign Exchange Risk
Companies face three main types of foreign exchange exposure: transaction exposure, translation exposure, and economic (or operating) exposure.
Let’s explore these in more detail:
- Transaction Exposure
Transaction exposure arises from actual business transactions conducted in foreign currencies. For example, a US company purchasing equipment from a supplier in the Eurozone may face unexpected costs if the exchange rate between the Euro and the Dollar changes between the time the order is placed and the invoice is paid. If the Euro strengthens against the Dollar, the cost to the US company in Dollars will increase, resulting in additional unforeseen expenses. This kind of exposure is straightforward and directly linked to specific business transactions.
- Translation Exposure
Translation exposure, also known as exchange rate exposure, occurs when a company consolidates the financial statements of a foreign subsidiary from its local currency into the parent company’s reporting currency. This can lead to apparent changes in financial performance due to exchange rate movements rather than actual business performance.
- Economic (or Operating) Exposure
Economic exposure is the long-term impact of unexpected currency fluctuations on a company’s future cash flows and market value. This type of exposure can influence strategic decisions, such as whether to invest in increasing manufacturing capacity or perhaps to reduce exports. Economic exposure affects a company’s competitive position and can have far-reaching implications.
Strategies to Mitigate Foreign Exchange Risk
Once a company identifies its foreign exchange exposures, the next step is to decide whether to mitigate the risk and, if so, how. Some companies may choose to accept the risk as a cost of doing business, while others may actively manage it using various strategies.
- Transact in Your Own Currency
One simple approach is to conduct transactions exclusively in your own currency. A strong brand or competitive position may allow a company to invoice and receive payments in its domestic currency, transferring the exchange rate risk to the customer or supplier. However, this strategy may be impractical in cases where certain expenses, such as taxes or salaries, must be paid in local currency.
- Build Protection into Contracts
For companies engaged in long-term projects with significant foreign currency elements, it may be possible to include foreign exchange clauses in contracts. These clauses allow for adjustments if exchange rates deviate beyond a specified range, protecting profitability. However, they require strong legal language and careful negotiation and must be regularly reviewed to ensure compliance.
- Natural Foreign Exchange Hedging
Natural hedging involves matching foreign currency revenues and costs to minimise net exposure. For example, a US company generating income in Euros might source products from Europe for supply to the US, effectively offsetting Euro exposure. This approach requires sophisticated financial management and tracking of multiple currency exposures.
- Hedging with Financial Instruments
Financial instruments, such as forward contracts and currency options, are the most complex but widely recognised methods of hedging foreign currency risk. Having the TreasuryONE dealing team in your corner ensures that clients understand the impact of the financial instrument selected and can focus on running their business. In contrast, the team at TreasuryONE focus on micro-managing the currency exposures.
- Forward Contracts: A forward contract allows a company to lock in an exchange rate for a future transaction, providing certainty about the cost in the domestic currency. This method is effective but requires precise alignment between the treasury function and cash flow management to avoid mismatches.
- Currency Options: Currency options give a company the right, but not the obligation, to transact at a specific exchange rate, offering flexibility if market conditions change. However, this flexibility comes at a cost, as companies must pay a premium for the option.
Choosing the Right Strategy
The decision to hedge foreign exchange risk depends on the company’s risk appetite, industry, and specific circumstances. Companies that choose to hedge must have robust financial forecasting and a deep understanding of their exposures. Overhedging due to overly optimistic forecasts or speculation on currency movements can be a costly mistake.
Even companies that decide not to hedge should still understand the impact of currency movements on their financial statements to avoid distorted performance assessments and poor decision-making.
Conclusion
Foreign exchange risk is just one of many challenges faced by companies operating internationally. A proactive approach to managing this risk can help protect profitability and ensure financial stability. At TreasuryONE, we provide expert guidance on foreign exchange risk management, helping companies navigate the complexities of global markets and safeguard their financial health. Whether through natural hedging strategies or financial instruments, our team can help you develop a tailored approach to managing currency risk effectively.
Remember, hoping for stable financial markets is not a strategy. It’s essential to have a plan in place to manage foreign exchange risk and protect your company’s financial future.