How to Centralize Foreign Exchange Risk Management in a Corporate Group?

Foreign exchange risk is a significant aspect of a company's liquidity management. This risk can substantially impact a company's financial results and lead to significant losses if not managed properly. In this guide, we examine different methods to centralize foreign exchange risk management within a corporate group.

Foreign Exchange Risk in International Trade

Foreign exchange risk in international trade is related to the fluctuations in exchange rates between the currencies used in a commercial transaction. When a company conducts a transaction abroad, it is exposed to foreign exchange risk because the exchange rate between the currencies can fluctuate before or during the transaction.

For example, if a U.S. company exports products to Europe and invoices in euros, it is exposed to foreign exchange risk because it does not know in advance how many dollars it will receive for its products. If the exchange rate between the dollar and the euro depreciates, the U.S. company could lose money if it does not hedge against foreign exchange risk.

Foreign exchange risk in international trade can therefore have a significant impact on a company's financial results, especially if the company operates in many countries where it is exposed to foreign exchange risks in multiple currencies. To limit this exposure, companies often use hedging methods to protect their cash flow and limit their foreign exchange risk in case of exchange rate fluctuations.

How to Assess Foreign Exchange Risk

To assess foreign exchange risk, companies must first understand their exposure to foreign exchange risk. This involves understanding all transactions related to foreign currencies and future cash flows that may be affected by exchange rate fluctuations.

Many companies use treasury management software (such as Agicap, for example) to assess their exposure to foreign exchange risk. These software solutions use real-time data to generate detailed reports on foreign currency transactions and the company's future cash flows. By using these reports, companies can better understand their exposure to foreign exchange risk and make informed decisions regarding foreign exchange hedging.

What Factors Influence Exchange Rates?

Exchange rate fluctuations are influenced by numerous economic, political, and geopolitical factors. Here are some examples:

1. Monetary Policy: A country's monetary policy can influence the exchange rate. If a central bank raises interest rates, it can attract foreign capital into the country, increase demand for the local currency, and thus raise the exchange rate.

2. Economic Events: Economic events such as employment reports, economic growth figures, or trade balances can impact exchange rates.

3. Political Events: Political events, such as elections, regime changes, political crises, or influential decisions like an embargo or sanction, can cause significant fluctuations in exchange rates.

4. International Trade: Exchange rates are also influenced by international trade. For example, if a country increases its export volume, it can strengthen demand for its currency, increase its value, and thus raise the exchange rate.

5. Speculation: Many investors speculate on exchange rate fluctuations to generate profits. Their actions can sometimes cause significant variations in exchange rates.

6. Central Bank Interventions: Central banks can buy or sell currencies to influence exchange rates in favor of their country.

7. Economic or Geopolitical Instability: Unforeseen events such as natural disasters, armed conflicts, political or economic uncertainties can lead to exchange rate instability.

Understanding these factors is essential for companies operating internationally so they can implement foreign exchange hedges that will limit their exposure to foreign exchange risk.

Different Types of Foreign Exchange Risks

There are several types of foreign exchange risks that companies may be exposed to. The two main types of foreign exchange risks are transactional foreign exchange risk and economic foreign exchange risk.

Transactional Foreign Exchange Risk Transactional foreign exchange risk is related to transactions that occur in foreign currencies, such as purchases or sales abroad. If the exchange rate becomes unfavorable, it can negatively impact the company's cash flows.

Economic Foreign Exchange Risk Economic foreign exchange risk is related to assets and liabilities denominated in a foreign currency. If the company has assets denominated in foreign currencies that it must convert into its local currency at some point, an unfavorable exchange rate fluctuation can result in a loss.

How to Implement Foreign Exchange Hedging?

What is Foreign Exchange Hedging? Foreign exchange hedging is a term used to describe the methods companies use to reduce their exposure to exchange rate fluctuations. Companies hedge against foreign currency fluctuations to limit their exposure to foreign exchange risk. Foreign exchange hedging allows companies to stabilize their cash flow and avoid financial losses due to unforeseen exchange rate fluctuations.

Companies use various financial instruments to hedge their foreign exchange risk, such as forward contracts, currency options, currency swaps, stop-loss orders, and other derivatives. The hedging method chosen by a company depends on the markets and currencies involved and the objective of the hedge. Foreign exchange hedging is commonly used by companies exposed to exchange rate movements, for example, when they import or export goods in foreign currencies, or when they have subsidiaries in foreign countries.

Note: Foreign exchange hedging is a tool for managing foreign exchange risk, but it does not completely eliminate the risk. Exchange rate fluctuations can still have an impact on a company's profitability, even if it uses hedging methods. However, foreign exchange hedging can help mitigate the impact of these fluctuations and stabilize the company's cash flow.

Who Hedges Foreign Exchange Risk? There are several methods to hedge foreign exchange risk, including forward contracts, currency options, and stop-loss orders. Companies can also use netting, a method that allows for offsetting payments and receipts between different subsidiaries of the group.

Foreign Exchange Hedging Methods The choice of hedging method depends on the company's objectives, its risk tolerance, the required hedging duration, and its knowledge of the available hedging products. It is essential for companies to understand the advantages and disadvantages of each hedging method before making a decision.

Forward contracts are agreements to buy or sell a currency at a specific and fixed exchange rate for a future maturity date. In other words, the forward contract allows locking in a specific exchange rate for a future transaction, which enables the company to protect itself against exchange rate fluctuations. For example, if a company is due to receive a payment in a foreign currency in six months and is concerned about possible exchange rate fluctuations by then, it can choose to sell a forward contract to sell the foreign currency against their own currency at a fixed rate on the maturity date.

By doing so, the company eliminates the risk of exchange rate fluctuations, as it knows the exact rate at which it will be able to exchange the foreign currency and thus avoid potential financial losses due to exchange rate variations.

How to Manage Foreign Exchange Risk

Managing foreign exchange risk involves several steps, including assessing foreign exchange risk, determining the appropriate hedging method, implementing a hedging policy, monitoring the foreign exchange market, and regularly reevaluating the hedging policy.

Companies can use treasury management software to manage their foreign exchange risk more effectively. These software solutions allow companies to perform sensitivity analyses to assess the potential impact of exchange rate fluctuations on their future cash flow. Agicap helps CFOs and group leaders measure these elements. Try it for free.