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Managing Foreign Currency Risk

financial charts / financial due diligence

Companies of all sizes are increasingly conducting business in a variety of currencies as they look for growth in new markets and procure more goods and services internationally. Businesses are affected by exchange rate movements in relation to overseas suppliers, customers and indirectly, their competitors. Exchange rate fluctuations could result in significant foreign currency risk and affect business results.

Companies earn revenues and incur expenses in foreign currencies as part of their transactions occurring outside of the United States. Accordingly, fluctuations in currency exchange rates may significantly increase the amount of U.S. dollars required to settle expenses transacted in a foreign currency or significantly decrease the U.S. dollars received in settlement of sales transactions from foreign customers. This risk is relevant for transactions, which require settlement in a currency other than a company’s functional currency. Put simply, a foreign currency transaction gain or loss is produced from redeeming receivables/payables that are fixed in terms of amounts of foreign currency received/ paid and is included in net income or loss in the statement of operations. The financial statements of companies with international operations also have exposure to currency translation risk. The balance sheets and results of operations for foreign subsidiaries or divisions of U.S. companies are translated to U.S. dollars for inclusion in the U.S. consolidated financial statements. As a result, changes in the exchange rate between the functional currency of the foreign subsidiary or division and the U.S. dollar result in a foreign currency translation gain or loss for financial reporting purposes in the United States. For U.S. companies with foreign subsidiaries or divisions, foreign currency translation is the process of expressing a foreign entity’s financial statements, which are maintained in a functional currency other than the U.S. dollar, in the reporting currency of the parent, which is the U.S. dollar. Translation adjustments, net of income tax effects, are included in other comprehensive income.

Identifying Currency Risk Exposure

Managing currency risk is important as financial covenants, business profits, cash flows, asset values, and competitive position can be affected by changes in exchange rates. While the extent of the volatility of changes in currency exchange rates is not predictable, it is important that the level of currency risk be understood, monitored and ultimately managed if a business is to flourish.

Generally, a company’s foreign currency risk exposure arises from one or more of the following:

  • Economic exposures arise from selecting markets and choosing office and factory locations as well as from the currency profile of competitors;
  • Transaction exposures arise from generating revenues and incurring costs in various currencies; and
  • Translation exposures arising from the revaluation of foreign currency balances (cash, receivables, payables etc.) in accordance with accounting rules.

Setting Policy to Manage Risk

There are a multitude of financial instruments available to assist a company in its currency risk management. However, for a company to achieve success, the policy should be robust. A company first needs to understand their risks to have a successful policy. This is more difficult than it seems given that:

  • Extracting good-quality information on actual and forecasted flows and assets by currency from internal financial systems is often challenging;
  • The economic (indirect) risks associated with competitor actions, the changing demand for products sold outside home markets and the pressure on local costs, when exchange rates move, can be hard to quantify; and
  • Each country, particularly in emerging markets, has its own regulatory constraints which may inhibit the conversion and movement of currency.

Once the key flows and assets by currency are identified and understood, the second stage is to understand business sensitivity to currency risk. How do changes in exchange rates affect the income statement and tax charges, cashflows, key financial/ regulatory ratios, bank covenants, asset values, and market position? This work will show where there are natural hedges and major sensitivities and when the effect of exchange rate variation will cause business pain and require action. The third stage is to understand what actions can be taken to adjust the business model to mitigate those strategic risks. Actions which can be taken are broad and range from amending prices or changing suppliers from one currency to another in the near-term to even moving the country of operations if the exchange rate change is believed to be too volatile to warrant the risk.

Using Financial Instruments to Hedge Risk

Often, companies manage their currency risk by using financial instruments (for example, forward contracts or currency options) to hedge risk. A hedge by definition is a financial instrument or compensating transaction to protect against loss. The use of hedges does not come without its own set of issues or complications. At times, there are inherent restrictions in the use of financial instruments, particularly in emerging markets. Also, there is a cost to hedging, whether it be the spread on a forward contract or the upfront cost of an option. There are many examples of companies that use financial instruments to reduce currency risk. Clothing retailers use them to mitigate their currency risk related to goods purchased from manufacturers in the Far East and against risk related to sales denominated in the Euro or Pound. For the next season, they will look to adjust prices or supplier costs to reflect new exchange rates subject to competitive pressures. Airlines similarly hedge the currency costs of jet fuel in U.S. dollars against local currency ticket sales in the short term but will look to amend ticket prices in the medium term to reflect ongoing currency effects on jet fuel costs.

Bottom Line

For companies increasing their global reach, foreign currency risk demands that company management develop effective policies to address the potential economic effects and the potential financial reporting effects.

The key take-away points are as follows:

  • Most foreign buyers generally prefer to trade in their local currencies to avoid foreign currency exchange risk exposure.
  • U.S. exporters who choose to trade in foreign currencies can reduce foreign currency exchange exposure by using one of the widely-used risk management techniques available, such as forward contracts or foreign exchange options.
  • The sometimes-volatile nature of the foreign currency exchange market poses a risk of unfavorable rate movements, which may cause potentially damaging financial losses.
  • The main objective of foreign currency exchange risk management is to minimize potential currency losses rather than profit from rate movements.

Reprinted with permission from Developments Magazine, copyright 2018.

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