A finance team’s guide to managing foreign exchange risk

When a company trades in goods or services overseas, or makes international inter-company transactions, it needs to minimise or mitigate the associated financial exchange risks. It used to be that only large multinationals had to worry about exposure to foreign exchange fluctuations. But the increasingly international nature of business means it’s now a reality for many mid-market companies.   

In this blog we outline:

• The key FX terms and concepts finance teams need to know
• The FX challenges facing mid-market finance teams
• How finance teams can manage FX risk.

Introduction: What is foreign exchange risk?

Companies incur foreign exchange risk when they engage in financial transactions in a currency other than their domestic currency. The risk is that exchange rates can move in ways that mean your company loses money. This risk is also known as FX risk, exchange rate risk or currency risk and the amount at risk is called exposure.

There are broadly three types of FX risk exposure:

• Transaction – when you pay or charge for goods or services in a foreign currency, there is a risk that the exchange rate changes between the agreement date and the payment date
• Operational – foreign exchange fluctuations can also affect your future cashflow
• Accounting (or translation) - when you have to convert foreign assets and liabilities into your home currency for reporting purposes.

In the complex world of international trade, multiple internal and external risk factors come into play. These include:

Internal risk factorsExternal risk factorsLack of financial visibility, particularly over cashflow and liquidityCurrency volatilityInaccurate forecastingChanges in interest ratesSiloed dataSupply chain disruptionsRelying on Excel to manage complex FX accountingGlobal events, such as a pandemic, war or political instability

Many of these external risk factors are difficult to foresee, and impossible to control. However, gaining financial transparency and visibility across your business and supply chain will help you to put effective FX policies in place to mitigate hidden or unexpected FX risks. Many finance teams also chose to work with an FX provider to reduce risk, save money and ease the administrative burden.

The key FX terms and concepts finance teams need to know

Spot Exchange Rate

The spot exchange rate is the current amount one currency will trade for another currency at a specific point in time. It’s often referred to as the open market price or transaction rate. Typically, it’s the rate recorded in the P&L account.

If you buy and sell currency, for example you receive dollars into a euro account, you will automatically receive an – unattractive! – spot rate from your bank. In reality, most companies don’t do this. Instead, they practice what is called ‘self-hedging’. This normally means they will either:

• Set up a separate foreign currency bank account, or a subsidiary entity in that country, to avoid exposure to transaction risk
• Partner with an FX provider to get a significantly better spot rate if their FX transactions are less frequent.

Businesses are most likely to be affected by FX risk when they:

1) Pay expenses, such as software subscriptions, advertising or travel, in another currency using a credit card

2) Need to pay suppliers in different currencies

In these first two situations you are effectively paying the spot rate.

3) Need to repatriate profits from an overseas subsidiary. This treasury movement is the main FX challenge facing many businesses. It’s also where establishing a relationship with an FX provider is particularly beneficial; both for accessing a good spot rate and for hedging. 

FX fees are another opportunity for finance teams to make significant savings. Banks will typically charge an FX fee of 200-500 basis points (2-5%). However, if you establish a relationship with an FX provider, either independently or through an accounting software partner, you can typically guarantee a charge of around 50 basis points (0.5%).

FX hedging

A hedge is like an insurance policy to help manage risk by minimising or offsetting your exposure. You’re also gaining certainty by limiting your exposure to FX movements. For example, if a foreign subsidiary is budgeting to trade a USD1m profit and the group reporting currency is GBP, it might be wise to hedge part, or all, of the FX exposure if the plan is to repatriate part, or all, of the profits.

This scenario would use a European Option (see below) to sell forward an amount of USD for GBP for an agreed future rate your company is comfortable with. The same would apply if the subsidiary was planning to repay a loan to group.

Another situation that often arises is making an investment or loan into a subsidiary. Here, you would be looking to buy forward, say USD, to make an investment at a future date.

Having access to the data to identify and understand your FX exposures is key to good Treasury Management. How you then use a good spot rate or hedge forward, will determine how much you minimise the FX transaction costs, or reduce the risks of adverse movements through forward contracts (hedging). If you are dealing in FX transactions of £500,000 or higher it could be costing your business £15,000 a year.

FX Options (also known as Forex or Currency Options)

Foreign exchange options can help companies hedge against exchange rate fluctuations. They are derivatives that give the right (but not the obligation) to exchange one currency into another at a pre-agreed exchange rate at a specified time. There are multiple types of FX options, but the two most common are:

• European-style options: where you agree to buy and sell a currency at any point between two dates. For example, you could get a hedging rate for a sale of $1M into € within the next 3 months to reduce your exposure.   
• American-style options: where you have to sell on a particular date.

Here’s a simple FX risk scenario example:

Your US subsidiary is forecast to make a $4M annual profit but the dollar is expected to weaken over the year. To mitigate your currency exposure, you decide to fix, or hedge, your Q1 $1M forecast profit. This hedging allows you to move the money at the locked-in rate and avoid FX exposure. Alternatively, you could hedge half your exposure ($0.5M) to reduce the impact of any major currency swings.

The FX challenges facing mid-market finance teams

Finance teams operating in a multi-currency world are typically either:

1) Trading in multiple currencies within a single entity structure

2) In a group structure with the parent company reporting in one currency and subsidiaries trading in other currencies.

As such, they face multiple day-to-day accounting complexities including:  

• Budgeting: you need a table of currency rates to:

-        Manage FX transactions in your P&L

-        Conduct balance sheet revaluations

-        Compare against fixed, or variable, budgets.

• Automatic data capture and reporting: you need to capture income and expenditure at the correct exchange rate, and have the ability to value in your group and subsidiary exchange rates at a pre-determined average rate
• Re-valuing all your FX balance sheet items at a month-end rate.

How can finance teams manage FX risk?

Amongst all the uncertainty around rising interest rates, inflation and world events, one thing is certain. CFOs cannot neglect FX risk management and its influence on the balance sheet. Yet, according to research from American Express*, 43% of UK SMEs don’t actively manage the risk posed by foreign currency fluctuations.

*American Express/YouGov survey of 1000 UK SMEs, July 2019.

Here are three ways finance teams can manage FX risk:

1) Have the right finance technology in place 

If you’re trading in different currencies, you need a Financial Management System with treasury management capabilities built in. Managing the accounting complexities we’ve outlined above in Excel is hugely time-consuming and error prone.

2) Ensure you have a reliable data source

Comprehensive and real-time data is key to understanding your FX exposures. You’ll also need a reliable data source if you’re using hedging instruments to manage FX exposure. That’s why it’s essential to collect and seamlessly integrate data from all your business systems. 

3) Work with an FX partner

Streamlining and automating international payments, processes and workflows can help manage FX risks and costs. For example, AccountsIQ integrates with the global payments company TransferMate. This means businesses can access competitive spot rates and generate international payments directly from their finance system for faster settlement time.

Darren Cran, COO, AccountsIQ

Managing FX risk effectively is crucial for international businesses. As AccountsIQ’s COO, Darren Cran, explains:

“We’re living in what is often referred to as VUCA* times. Multiple disruptive events are happening at the same time around the world. That, inevitably, leads to additional currency volatility.

We’re seeing that with all the major currencies; but it’s even worse with secondary currencies.  In this business environment, having a robust treasury management approach is vital. Essentially, that involves ensuring you get the best spot rates and have a hedging strategy in place.”

*Volatility, Uncertainty, Complexity and Ambiguity