Guide To Foreign Exchange Risk Hedging
Foreign Exchange risk hedging practices involve using currency contracts such as options, forward contracts, and swaps. It entails what a business will do so that it can avert business risks associated with fluctuations in the foreign exchange rate. Any business that conducts international business is likely to experience these forex risks. As a result, therefore, businesses should use forex risk hedging services offered by various institutions to avert costs associated with currency risks.
Types of foreign exchange risks
Conducting cross-border businesses means that foreign currency fluctuations can crush and even diminish returns. This happens when the company has to convert money earned from international trade to domestic currency. Equally, it can result from converting payables from the local currency to foreign currency. Before dwelling into foreign exchange risk hedging git is important to understand the foreign exchange risks that businesses encounter when processing foreign currency. Here are the risks:
- Transaction risks
These are risks associated with the actual trade happening in foreign currency. It results because of differences in the exchange rate between the payment date and the date of settling the transaction because of the time difference. For instance, for a payable, it is the difference in time when a purchasing order is placed and when the invoice is settled. This can result in a transaction gain or loss depending on market movement and the extent depends on the amount of payment.
- Translation risks
This refers to the translation of the financial statement of a subsidiary from the domestic currency to the reporting currency of the parent entity. The translation is necessary for the parent company to provide consolidated accounts. Although this approach may seem simple it has risks associated with price movements of the foreign currency.
- Economic or operating risks
These risks result from fluctuations of currency that affect the market value and cash flow in the long term. This type of risk can influence long-term strategic decisions of the business. For instance, if a domestic currency strengthens relative to a foreign currency where a company is domiciled then it makes competing products affordable and attractive.
Minimizing foreign exchange risks
Before thinking of mitigating the risks it is important to consider whether the foreign currency fluctuations are factored in business operations. Some businesses have a provision of the exchange costs in their earning and some have massive profits that cushion against foreign exchange volatility. To mitigate the foreign exchange risks businesses should, therefore:
- Transact in one currency
For those businesses that are competitive in the market, they can opt to offer their services and products in one currency. The company can insist on giving invoices and making payments in one currency. Thus will not affect returns of the business as the foreign exchange risk is passed to the local supplier or consumer. However, this can be challenging especially considering there are specific costs that have to be settled in a local currency such as taxes and salaries.
- Protect your business contracts
Sometimes businesses or large projects such as in the mining and energy industry involve some foreign currency elements since they are long term contracts. Since it is a long term project foreign currency exchange rates may fluctuate significantly and thus there is a need to insert foreign exchange clauses in the contract. This will cushion the businesses should exchange rates fluctuate significantly.
- Foreign exchange hedging
This happens when the company can match costs and revenues in foreign currencies so that risks are mitigated. For instance, a US business operating in Europe paid in Euros can decide to source products for supply to its US business so that they can spend the Euros.
Foreign exchange risk hedging tools
The best way to hedge foreign currency exposure is by having hedging arrangements through financial tools. Methods of hedging include forward contracts, currency options, forex swaps, and money market hedge.
- Forward contracts
This is a legal contract that gives one the right to buy and sell foreign currency at a predetermined price in the future. It is an interest differential between the domestic and foreign currency with foreign premium quoted for up to 12 months in the market. The forward contracts eliminate uncertainty around international transfers and thus there is no worry of forex volatility.
- Currency options
They are similar to the forward contracts and one has the right to buy and sell foreign currency at a given rate before or on a particular date. There is no obligation to complete the transaction once the contract expires. One can exercise the option if the exchange rate is favorable at the current market rate. If it is not then one can wait for the option to expire and carry the transaction at the current market rate. However, the flexibility is not free and the businesses will have to pay a premium for the same.
- Forex swaps
This involves parties exchanging equivalent amounts of currencies at a particular time and then reversing the exchange later. The parties have a prior exchange rate agreement and this helps the business hedge against foreign exchange risks.
- Money market hedge
It involves completion of transactions on current rates but the business has to buy foreign currency from the bank and hold them until the transaction goes through. The bought currency earns interest in the bank until the actual transaction takes place in the future. This is ideal where it is hard to use future contracts.
Awareness of foreign exchange risks
Foreign exchange risks are common for international businesses and businesses should be aware of the risks. The choice of foreign currency risk hedging depends on how much exposure the company has and the type of industry they operate in. it is important to be aware that hedging depends on financial forecasting and understanding of forex risks. Over-hedging might prove to be a costly mistake if the business doesn’t correctly anticipate the currency movements. It is also necessary to be aware that different institutions offer different foreign currency risk hedging tools. Most importantly the foreign exchange risks are just part of the many risks that businesses operating outside the domestic market have to incur.