FX risk management: from FX risk exposure to hedging optimization

Foreign currency exchange risk management is a complex topic, and it's on the top of many businesses' agendas that trade goods globally now when the global economic situation has been uncertain, there's political instability in Europe, and interest rates are on the rise. These factors can all have a significant effect on countries and, therefore, their currencies.

Our article provides a brief overview of what FX risk is, what is FX risk exposure, and how market volatility affects businesses, and we will move to the more practical side and introduce exposure analysis, hedging, at-risk calculation, and hedging optimization.

What is FX risk?

Foreign currency exchange risk (typically referred to as FX risk) is the risk posed by fluctuations in exchange rates. When a business operates in several markets, chances are high that the company will need to deal with multiple currencies so that it will take on FX risk.

FX risk can arise from a company's transactions (i.e., when a company generates revenue in a foreign currency but incurs costs in another currency), from its investments (i.e., when a company owns assets denominated in a foreign currency), or from its financing (i.e., when a company has debt denominated in a foreign currency).

There is always the potential for changes in the value of foreign currencies (some currencies are also more volatile than others), which can seriously impact the bottom line of a business. For example, if a company sells products in euros but incurs costs in US dollars, a decline in the value of the euro relative to the dollar will eat into the business's profits. Conversely, an appreciation of the euro could boost profits. Therefore, managing FX risk is essential for any business with international operations to minimize the risk and the costs.

Introducing FX risk exposure

FX risk exposure is the potential for loss that a company faces due to fluctuations in foreign exchange rates. FX risk can arise from several sources, including transactions in foreign currency, investments in foreign markets, and exposure to currency risk through loans or credit lines denominated in a foreign currency. While FX risk can never be eliminated entirely, by implementing hedging strategies, companies can mitigate their FX risk. Moreover, companies can protect themselves from the potentially devastating effects of sudden currency swings by understanding the various sources of FX risk and taking steps to hedge that risk.

How does market volatility affect businesses?

Market volatility is the fluctuations of market prices. The changes can be influenced by various factors, including political instability, central bank policy, economic indicators, or even natural disasters. Market volatility can significantly impact FX markets, as it can lead to sudden changes in demand for different currencies, and businesses trading goods globally can often feel the consequences. For example, if a company imports goods from another country, a sudden drop in the currency's value could make those goods more expensive. Similarly, if a company exports products to another country, a sudden increase in the currency's value could make those products less competitive. As a result, businesses must often carefully monitor market volatility to minimize the risks associated with foreign currency exchange.

The role of a market data provider?

When you are a business that is trading goods globally, using a market data provider to stay up-to-date and get real-time currency prices is a must. A market data provider is a company that collects and distributes financial market data. Data can include prices, volumes, dividends, and earnings. Currency market data is collected from central banks, commercial banks, and other financial institutions. They then distribute this data to market participants, including currency traders, investors, and speculators. If you are using a risk management solution for managing currency risk, it’s essential that the solution can retrieve daily rates as well as historical data from market data providers.

FX Risk management in practice

To go beyond theory, we wanted to give you an overview of how managing FX risk actively can minimize losses or realize possible gains. The FX risk management starts with a company having currency exposure, meaning that the business is expecting account receivables or loans in a different currency.

The first step in risk management is to analyze exposure and create reports on the effects the currency can have on the company’s liquidity. Once you have identified risks that could occur from a specific exposure, the second step is to hedge the currency. For hedging, it’s essential to analyze the risk profile of each currency. To go above and beyond, it’s possible to optimize hedges to ensure that you are not only reducing the risk, but at the same time, you are also minimizing hedging costs.

Exposure analysis & reporting to get ready for hedging

FX exposure analysis and reporting is a crucial part of FX risk management. FX exposure refers to the potential loss that a company may incur due to changes in foreign exchange rates.

FX exposure can be classified into two types: transaction exposure and economic exposure. Transaction exposure arises from companies' transactions denominated in foreign currencies, while economic exposure arises from changes in the value of foreign assets and liabilities held by companies.

FX exposure can significantly impact a company's financial performance and should therefore be managed carefully. FX exposure analysis helps companies to identify their FX exposures and assess their potential impacts for the short-term and long-term. In addition, FX exposure reporting allows companies to track their FX exposures over time and compare them with the FX risk tolerance levels that the company sets.

To make the most out of exposure analysis and reporting, it's essential to get data from all possible data sources, such as ERP and financial systems, and work with the data on accounts payables (AP), account receivables (AR), purchase orders, or actual cash flows.

When working with the long-term exposure analysis, it's helpful to look at historical data and cash flows to simulate your future exposure.

Analyzing exposures should happen by the entity, business unit, or division, or you could do it on the group level. Whether you are managing FX risk using Excel or a risk management solution, ensure you always have all the data available to make the best possible exposure analysis for your group or smaller entities.

The most vital part of FX risk management: hedging

Hedging is a strategy designed to protect against losses in the value of an asset. Hedging is most commonly used in the financial world to protect against swings in the value of the currency, but it can also be used to protect against changes in the price of stocks, commodities (e.g., coffee), and other assets.

Currency hedging is used by businesses to protect them against losses due to changes in the value of a currency. Currency hedging can be done using a variety of instruments, including forwards, futures, and options. Hedging against currency risk is a must for companies that do business in multiple countries or that have debt denominated in foreign currencies.

How does hedging work in practice?

A company that exports goods to another country may want to hedge against a decline in the value of the currency of its export market. For example, a US company that exports goods to Japan would like to hedge against a decrease in the value of the Japanese Yen. By hedging, the company can protect itself from a loss if the Yen would indeed decline in value later.

Similarly, a company with debt denominated in a foreign currency may want to hedge against a decline in the value of that currency. For example, if a company has borrowed money in euros and the value of the euro falls relative to the dollar, the company will have to pay back its debt with cheaper dollars. This could put the company at risk of defaulting on its debt. To protect against this risk, the company can hedge by buying euros forward or euro-denominated debt.

Of course, currency hedging is not without its risks. For example, if a hedged position moves against the investor, the hedging instrument can lose value, offsetting some or all the gains from the underlying position. In addition, hedging can add complexity and costs to an investment portfolio. It is crucial to understand how hedging works before implementing this strategy.

In some cases, it may not make sense to hedge a certain currency at all. In other cases, the best solution may be to only hedge a certain percentage of a given currency. Some companies may also choose a strategy to hedge every single currency. Ultimately, daily FX rates from a market data provider and historic rates can help FX professionals to make the best hedging decision to minimize the risk from currency exposure, however, the cost of hedging can be high – and we will get back to this in a bit.

Performing an At-Risk calculation

To measure the impact of your hedging strategy, you should perform at-risk calculation. It's a complex task that many companies still execute in Excel, even though there are solutions available on the market. When using an FX risk management solution, it's possible to use the variance/covariance approach or Monte Carlo simulation to identify which currencies should be hedged. It's also possible to calculate value-at-risk or cashflow-at-risk (CfaR) based on the available data in the solution and use incremental CfaR to evaluate the impact of hedging a particular currency. Factors such as currency correlations, risk horizons, holding periods, and confidence intervals should also be considered.

Hedge portfolio optimization: a vital step in FX risk management

While most companies hedge, not many companies look further and invest in hedging optimization so that they would not only hedge currencies to reduce the risk but also minimize the hedging costs. Hedging is not free for corporates – derivative dealing and management always come with costs such as transaction cost, opportunity cost, or the cost of financing the hedge. Most companies perform exposure analysis and reporting as well as hedging using a trading platform and banks, but fewer companies perform a structured risk analysis to identify optimization opportunities in a way that there is a perfect combination of minimizing losses, potentially gaining wins from market fluctuations, and combining it with minimal cost of hedging.

When deciding how which currencies or much to hedge, companies should balance the need to protect cash flows with the costs of hedging. By carefully analyzing their exposures and understanding the trade-offs involved, it's possible to develop hedging strategies that minimize costs while still providing ample protection against risk.

There is also not one right way of doing this, and it requires careful planning and balancing considering the risk levels. Some companies choose to only hedge currencies that are potentially high risk from a cash flow point of view, while others may hedge every single currency in their portfolio to some extent. The optimal hedging strategy for a company also depends on the level of risk that the business can carry without negatively impacting the bottom line of the business. While we tend to talk a lot about minimizing risk and losses, it's also possible to mitigate the losses by gaining money from hedging certain currencies. However, the cost of hedging should be considered.

How can you improve your FX risk management?

FX risk management and currency hedging are complex topics and hedging strategies can vary largely.

Our first advice would be to evaluate whether your current way of working is the most effective for your company. The more data you work with and the more derivatives you manage and hedge, it may be worth looking at solutions beyond Excel. Automation in the hedging process can have significant upsides, but it doesn't mean that it does not require that your team carefully manages the different currencies.

It's also good to talk to your peers: it's always interesting to see the approaches other companies take and what hedging strategies they have found the most useful. Working with risk management solution providers like Nomentia, you don’t only get a complex software solution for your team, but you also get access to experienced consultants that have experience working with global enterprises on setting up exposure analysis and reporting, identifying risk levels, hedging currencies, and optimizing hedging strategies.