What is FX Risk?
Foreign exchange (FX) risk is the risk associated with changes in currency exchange rates. FX risk exists when transactions take place in varying currencies outside of a company’s functional currency and occurs when a company’s exposure to the currencies it does business in is not properly managed.
If a volatile movement occurs in one of the transactional currencies and the company has not managed the exposure to that currency (either via organic exposure elimination or hedging), then they are susceptible to negative impacts to their earnings per share (EPS) and earnings before interest, tax, depreciation and amortization (EBITDA).
Different Types of FX Risk Management
Foreign exchange risk is the risk associated with fluctuating exchange rates, which can result in financial losses due to unfavorable exchange rates. The main types of foreign exchange risk are:
- Transaction risk is the risk of incurring losses due to exchange rate movements that occur between the time a commercial transaction is entered into and the time it is settled. This risk is particularly of concern for companies that conduct business across international borders and have significant international receivables and payables.
- Translation risk is the risk associated with the translation of a company’s financial statements into the currency of the reporting entity. Translation risk can arise when a company reports its financial statements in a currency other than its functional currency, or when a company reports its financial statements in a different currency than the currency of the subsidiary.
- Economic risk is the risk associated with changes in the economic environment that can have an adverse impact on a company’s operations. This risk can arise from changes in exchange rates, interest rates, inflation, and other macroeconomic variables. Economic risk is particularly relevant for companies with significant international operations.
- Liquidity risk indicates the ability of an organization to absorb FX volatility in its cash flow. Companies who cannot absorb FX unpredictability will face issues paying bills, repaying loans, making payments to suppliers, and running their businesses effectively.
How to Mitigate FX Risks
To avoid impacts to earnings, organizations must work to manage their FX exposure and risk. Organizations can reduce FX risk by organically eliminating exposures internally or by hedging exposures through balance sheet exposure management and cash flow exposure forecasting.
- Balance sheet exposure management: entails treasury professionals measuring, monitoring, and managing currency exposure and the associated risk from their balance sheet. The benefits of balance sheet exposure management include:
- The ability to manage EPS at risk to the industry MBO of less than $0.01
- Increased exposure identification
- Increased visibility to exposures
- Reduced program costs
- Reduced FX risk
- Improved hedge program
- Cash flow exposure forecasting: consists of the creation, analysis, and management of currency exposure from forecasted transactions and cash flows. The benefits of cash flow exposure forecasting include:
- Improved predictability of EBITDA
- Increased forecast accuracy
- Increased participation in the cash flow process
- Reduced cost of hedging
Hedging Strategies for Managing Currency Risk
FX risk, also known as currency risk, can be managed through hedging strategies. These strategies include: futures contracts, forward contracts, and options.
- Futures contracts: a futures contract is a standardized contract between a buyer and seller to buy or sell an asset at a predetermined price at a specified time in the future. Futures contracts are used to hedge against price fluctuations in commodities, currencies, and other financial instruments. Currency contracts allow for exposure to changes in exchange rates and interest rates of different currencies.
- Risk: Futures contracts are risky because agreed upon transactions must take place by the predetermined date and at the predetermined price, regardless of the current market price.
- Benefit: Futures contracts hedge against price fluctuations and can also be used to speculate on price movements. Futures contracts also provide greater liquidity than other financial instruments, as they are traded on exchanges that are closely monitored by regulatory authorities.
- Forward contracts: a forward contract is a customized (non-standardized) contract between two parties to buy or sell an asset at a specific price on a future date.
- Risk: forward contracts are high-risk contracts, since they are traded over-the-counter (OTC) instead of on centralized exchanges that are regulated and show transparent pricing and contract data. As well, they carry risk similar to futures contracts, where the forward rate specified in the contract may differ widely from the spot rate on the agreed to settlement date.
- Benefit: since businesses can lock in a price for the asset in advance, they know the exact cost of the asset, which can help them better manage their budget and cash flow. In addition, forward contracts are completely customizable and can be tailored to meet the needs of both parties.
- Options: an option is a financial contract that grants the holder the right, but not the obligation, to buy or sell an underlying asset at a specific price on or before a certain date. Options come in two varieties, calls and puts. A call option will give the holder the right to buy the underlying asset, while a put option will give the holder the right to sell the underlying asset.
- Risk: when buying options, the downside potential is the premium spent on the option. When selling calls, the downside potential is unlimited. When selling puts, the downside potential is limited to the value of the stock.
- Benefit: buying and selling options offers investors a way to gain exposure to potential market volatility without having to commit to the full purchase price of the underlying asset. Options differ from futures in that options are contracts that give the owner the right to buy or sell the underlying asset, while futures are contracts that obligate the owner to buy or sell the underlying asset. In addition, options can be bought or sold at any time before the expiration date, while a futures contract must be bought or sold on or before its expiration date.
How Kyriba Helps Organizations Manage FX Risk
By understanding FX risk and planning for it, companies can reduce their exposure and protect their bottom-line from any unexpected changes in exchange rate values. Kyriba has the tools and features to help companies identify and manage their FX risk, allowing them to confidently expand their operations into new markets.
Kyriba’s Risk Management delivers pre-trade, trade, and post-trade capabilities that introduce analytics to your FX programs, helping businesses protect balance sheets and income statements from currency fluctuations.