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Managing foreign currency risk: the dos and don'ts

30 June, 2015David Morrish

The recent, well-documented, volatility in the foreign exchange markets is a timely reminder, if it were necessary, of the need for those trading overseas to have a viable strategy in managing foreign exchange exposure when trading overseas. The underlying risks haven’t changed: it’s just the situation that is new.

Using the euro to illustrate how those risks may manifest themselves in reality, I have reproduced below a table from the European Central Bank plotting the value of the Euro against the British Pound over the last 12 months. 

British Pound - Euro Exchange Rate July 2014 - June 2015

Frankly it doesn't matter if you are buying or selling foreign currency or domestic currency, there is always currency exchange risk for someone somewhere in the transaction.

Let’s take an example of a UK exporter selling goods to the Eurozone. The deal is stuck for a regular shipment of goods to say France, with a sale price of £10,000 per month. The time is October 2014. The UK exporter has a good product, well priced and is confident of being able to insist on payment in pounds. The buyer in France is prepared to take the foreign exchange risk as the euro had been relatively stable.

Fast-forward to March 2015 and the picture is very different; the euro having lost some 10% in value over the period. But the UK exporter is safe isn't it? Goods have been priced in pounds so there will be no foreign currency loss. Well, true but if the goods were worth importing to France when a euro was worth £0.79, are they still desirable now that the euro has dipped to just £0.70? Are there other manufacturers within the Eurozone that the buyer could switch to? In other words, has the UK exporter just become uncompetitive, not because the product or service has somehow become inferior, but entirely because of external factors?

So it is essential that every organisation trading internationally has a strategy for managing foreign exchange and that this is kept under constant review.

Forex Risk Management Strategies

But what are the strategies that could be adopted? There are various tried and tested methods of hedging foreign exchange exposure, but first thought needs to be given on understanding an organisation’s exposure and how to react…

Do Nothing

Having established that risks exist, it may seem a little strange to think that ‘Doing Nothing’ is any sort of strategy at all! What this does not mean, of course, is that an organisation relies on inertia! As a considered act, provided it is made after carefully weighing up the pros and cons before making a decision to take no action, this is entirely legitimate.

So what might these considerations be?

  • Transactions are low in both frequency and value so the management time spent in hedging the exposure would be disproportionate to the risks
  • The net margin is sufficiently high to absorb even significant adverse movements
  • Over a period the movements both up and down in the exchange rate is such that the overall effect is neutral

There will be other reasons in addition to these.

Fix Everything

The philosophy behind this is that organisations make their profit from the underlying transaction rather than by playing in the foreign market. So the message is to eliminate the foreign exchange exposure and stick to what it is best at!

The risk of adverse movements in the exchange rate therefore no longer exists, but equally in the event that rates move favourably, fixing everything also removes the ability to make an extra turn of profit.

Hedge Part

Essentially this is all about getting certainty for a percentage of an organisation’s exposure and ‘taking a view’ on the balance. So, for example, the exchange rate could be fixed for individual large transactions whilst the higher volume, lower value transactions could be left to the vagaries of the market.

The important message for any organisation is that if it is exposed to movements in the exchange rate then it needs strategies to manage that exposure. If ultimately it decides to take no action, this must be a conscious decision rather than a glorious accident!