12 June 2024

Effective Foreign Exchange (FX) Risk Management

Understanding and managing foreign exchange risk often goes in the “too hard” basket. Which is why we have put together this easy-to-read guide to help you achieve more effective FX Risk Management.

Understanding and managing foreign exchange risk often goes in the “too hard” basket. It’s a zero-sum game anyway, isn’t it? What I lose in FX losses this month, I’ll make back in gains next month.  Why should I care about effective foreign exchange risk management anyway?

Well, you might be lucky. You might stay in business long enough to come through the cycles of the global foreign exchange market but it will be good luck rather than good management. We have seen many well-run businesses see a year’s profitability disappear through poor FX risk management.

“Managing FX risk doesn’t have to be hard. Making regular, small hedging decisions by monitoring your exposure and adjusting your hedging levels, rather than large one-off calls around your directional view of the markets, will ensure your business survives.”  Richard Eaddy, CEO , Hedgebook

Introducing effective FX risk management basics

In this overview we cover the basics to help you understand the world of foreign exchange. If you would like to get an easy to read copy of this material plus some more in-depth examples and guidance – our FX Risk Management eBook will take you through all you need to know to navigate the world of foreign exchange like a pro.

But let’s get a good grounding to start with. If you read to the end you should understand your exposure, have clear metrics around what you are trying to achieve or protect e.g. budget rate, know the products you can use to hedge the risk then regularly monitor, re-evaluate and adjust.

Don’t leave it to chance. Read on – and if you would like some easy-to-use software to support your FX risk management practices – please let us know.

Exactly what is foreign exchange risk?

Let’s start with the basics.

For companies that sell their goods and services overseas and get paid in a foreign currency (aka exporters), foreign exchange risk is the likelihood that a movement in exchange rates will result in the company receiving a lower amount of their domestic currency than originally planned or anticipated.

For companies that import and pay foreign suppliers in foreign currency (aka importers), it is the likelihood that a change in exchange rates will mean the company has to pay more than planned or anticipated.

Why hedge your FX risk?

Managing a company’s FX risk may seem complex, costly or time-consuming. Sometimes it is also perceived to be speculative and, therefore, a potentially dangerous pastime. However, doing nothing can be risky as well, especially if exchange rates move against you.

Companies can reduce their exposure to FX by managing these risks, but can also achieve the following benefits:

  • Minimise the effects of exchange rate movements on profit margins
  • Increase the predictability of future cashflows
  • Take away the need to try and predict where exchange rates are heading
  • Help with the pricing of products sold overseas
  • Slow down the effect on a company’s competitiveness if the exchange rate moves against you

It makes sense that if risks can be reduced then steps should be taken to protect the company. Often the purpose of hedging FX risk is to smooth the severe upturns and downturns that are seen in the FX markets. Hedging though, doesn’t need to be complicated. Understanding the basics is reasonably straightforward and banks, brokers and advisers are on hand if assistance is required.

Six steps to managing your FX risk

As with most business practices, if you are disciplined about following a process when managing your foreign exchange risks then you can mitigate some of the pitfalls that many exporters and importers fall into.  This simple six-step process is a logical approach which helps reduce the risks that a more informal approach can bring.

STEP 1 – Identify the FX Exposure

This involves identifying and measuring the foreign exchange exposures you need to manage:

  • For an exporter it will be the expected receipts in a foreign currency for sales you have made or expect to make.
  • For an importer it will be the payments in a foreign currency for goods or services that you have bought or expect to buy.

You will need to think about timing i.e. the day, week or month you expect to be paid or need to make a payment. Often the timing is less certain for an exporter than for an importer. For an importer, it may be an invoice that will need to be paid on a certain day, based on the agreed payment terms with the supplier.

Obviously, the amount is important:

  • For an importer it is likely you will have certainty over this, especially if it is based on an invoice.
  • For an exporter it is often less certain, so as a general rule it is better to err on the side of caution and cover a lesser amount rather than being over covered.

It maybe you expect to receive £100,000 but you may only cover £80,000 as history shows that some of these receipts do not arrive until the following month. Be careful you are clear that the amount you are covering is the foreign amount or the domestic amount. It is easy to be confused on this.

Whether you are an importer or an exporter you may have some offsetting risks e.g. As an exporter you are receiving regular amounts of foreign currency, but you may also have some payments to make in the same foreign currency.

From a risk management point of view it reduces your risk if you can offset these two amounts, the incoming and the outgoing, so that you only hedge the net amount. Again, this will depend on the timing of the receipt and the payment.

For an importer you would normally only cover the known amounts you have to pay, unless you are regularly making payments every month. For exporters it is more likely that you will cover not only committed receipts but also you may cover forecasted receipts.

This means that you need to have confidence that you will receive ongoing receipts out into the future. Depending on the currency you are dealing with there may be an advantage to hedge further out through the impact of forward points (discussed separately).

FX forward points are quite often misunderstood so it would be timely after you’ve finished this article to drill down a bit more into how FX forward points are calculated.


STEP 2 – Develop an effective FX risk management policy

Once you have identified your FX exposure it is then important to formulate a risk management policy that you follow in a disciplined way. This policy can be developed by yourself or you can use your bank or a treasury adviser/consultant to help you.

Depending on the size of your organisation, normally the board of directors would approve the policy and give senior management the authority to act within it. The only time senior management would go back to the board would be if they wanted to do something that was outside of the policy.

Why your risk management policy might be different to another organisation’s:

  • Your risk appetite – are your shareholders/directors risk averse?
  • Your competitive situation – do your competitors’ hedge?
  • Are you an importer or exporter?

The areas that a typical risk management policy will cover off are as follows:

  • What are the objectives of the policy?
  • What are the Board’s and management’s responsibilities
  • When should the FX exposure be hedged?
  • What hedging instruments can be used and under what circumstances?
  • How is the performance of the company’s hedging measured?
  • What are the reporting requirements?

STEP 3 – Ascertain and measure your budget rates and other goals

For most companies it is important to protect the budget rates that have been agreed prior to the start of the financial year. For importers it may be a costing rate for a particular job or event that is important.

These may well be the underlying reasons to hedge, so that these rates are fully protected. It is important that these rates are identified and measured. Treasury management software today can help track and measure these key rates to make the hedging decision easier.

STEP 4 – Formulate your foreign exchange hedging strategy

Having a risk management policy is not enough to ensure success with your FX hedging. You also need to formulate a hedging strategy that works within your policy and gives you the outcomes you desire.

It is vitally important that you have access to accurate information when looking at your strategy. You need to have good visibility over your expected cashflows, the hedging you may already have in place and where exchange rates currently are.

You may require some outside help to formulate your strategy. Again, your bank or a treasury adviser/consultant can assist with this in terms of the instruments you should use, the exposures you are hedging and the amount of risk you are prepared to take.

STEP 5 – Execute your hedging strategy

Once the hedging strategy has been formulated the next step is to execute. Just as it is important to understand the exposures you are hedging,, it is also important you understand the impact of the hedging you are putting in place. For those using FX forwards this is simpler than if you are also using options as a hedging instrument.

The old saying that if you can’t explain to your board the instruments you are entering into and the impact on your FX position then you probably shouldn’t be entering into them still stands. Having access to treasury management software that shows the outcomes of the hedging strategy helps with the understanding and with the decision to enter the strategy or not. Better yet being able to model your FX exposure against your treasury policy limits increases your chance of making better hedging decisions particularly in volatile markets.

STEP 6 – Evaluate the results and adjust if needed

The final step in the hedging process is to evaluate and measure the results, and if necessary adjust the strategy.

The basis of the evaluation will depend on the overriding reason to hedge. Was it to protect a budget rate, a costing rate or merely to give some certainty of cashflow?

To be able to measure these results you need to be able to accurately track the hedges you have put in place and compare, for example, to the budget rate or the spot rate on the day. This will require the ability to measure the weighted average exchange rate achieved for a particular period and to compare against the yardstick you have chosen. This is possible within a spreadsheet but easier with a system.

What financial instruments manage FX risk

The instruments used to manage FX risks are FX forwards, FX options and FX swaps. Within options there are many different types but for small to medium sized importers and exporters most use vanilla or simple option structures.

 Forward Contracts

Forward contracts allow a company to fix the exchange rate at which it will buy or sell an agreed amount of foreign currency in the future. They are the most commonly used FX hedging instrument due to their flexibility, as they can easily match future transaction exposures.

For example, if a UK exporter expects to receive USD 100,000 in three months’ time they can lock in a rate today for that date by selling USD 100,000 and buying their own currency. This rate is a combination of the current spot rate (i.e. today’s exchange rate) plus or minus an adjustment for three months forward points.

The forward point adjustment is explained separately. By entering into the forward contract the company has fixed the rate that the expected receipts will be converted into their domestic currency, no matter if the exchange rate moves up, down or stays the same between now and the maturity of the contract in three months’ time.  If you would like to see how this works in practice using Hedgebook – check out this quick forward exchange contracts overview in our help guide.

Forward contracts are easy to use and there is no purchase price – hence their popularity with importers and exporters. However, there is a contractual commitment to deliver to a bank or FX broker a fixed quantity of foreign exchange at a future date. If you can’t deliver the funds on the agreed day then the forward can be terminated or extended to a new value date. A terminated contract will likely result in some gains/losses depending on the prevailing market rate versus the contract rate. An extended contract will be adjusted for forward points.

FX options

An alternative hedging instrument to forward contracts is an FX option. A plain vanilla purchased option gives more flexibility when compared to a forward and are often used when there is a lower level of certainty in the expected exposure that the option is hedging.

For example, a business is bidding for a new contract but is uncertain whether it will win the business, or perhaps there is a poor track record in the accuracy of forecasts.

A purchased vanilla option will give the company certainty around a known amount of foreign currency at a known worst rate (the strike) but there is no obligation. If the option is not required, the company can simply walk away. Such options come at a cost, the premium, and is akin to the premium on an insurance policy.

Options can also be sold which generates a premium to the seller, however, this is widely discouraged. If the exchange rate goes against the seller the downside is unlimited. The exception to this is when the sold option is part of a structure.

The simplest example of this is a zero-cost collar. Many importers and exporters shy away from paying a premium for an option and so an option with no premium is more attractive. A zero-cost collar is when the company simultaneously buys and sells an option with the premium paid for the bought option offsetting the premium received for selling an option.

As you are not paying a premium, you do not get unlimited upside, as you do with an outright bought option, but equally you limit your downside.

Effectively you lock in a range of outcomes:

  • a best case whereby the sold option is exercised by the counterparty,
  • a worst case whereby you exercise the option that you have bought,

or if the exchange rate is between the ranges neither option is exercised and you are free to do a spot FX deal at the current exchange rate.

There are many other variations of structured option products with a wide variety of payoffs under different exchange rate outcomes. A leveraged, or ratio, option is where the exporter or importer buys one option and sells two, three or more options at the same time. The advantage of doing these types of options is that it improves your best-case rate.

The disadvantage is that if the sold options are exercised by the counterparty, you may end up with more cover than you originally wanted, at a rate you are no longer happy with. Many companies have got into trouble using leveraged or ratio options, however, if the ratio is low, i.e. two times – and the implications are fully understood, they do have merit for a portion of your hedging requirements.

Participating forwards

Participating forwards are another common hedging product. It offers a known amount of hedging at a known rate –  but also allows some participation in rates if they move in your favour. The bought and the sold option have the same strike rate but different notional amounts.

The advantage of the participating forward is that the strike or exercise rate is at a better rate than the FX forward that could be done at the same time. The disadvantage is that you don’t know how much cover you will have as you don’t know if you will exercise the bought option or the counterparty will exercise the sold amount. It is also more difficult to understand your overall position given the unknown notional amount unless you are using a treasury management system.

If you have a couple of minutes, see how you can use Hedgebook’s FX Exposure tool to visualise participating forwards on your hedging position and how the position might change under hypothetical exchange rate movements.

Finally: effective FX risk management doesn’t have to be hard

Following some basic rules as outlined above, getting some advice and making sure you have complete visibility over your position will help to smooth out some of the potentially harmful effects of foreign exchange volatility.

In most cases, good foreign exchange management will buy you some time to adjust your prices, or possibly shield you from the extreme moves that can really harm a business. It doesn’t mean taking a view on the currency and putting all your eggs in one basket.

Make informed decisions by having the best possible visibility over your foreign exchange position and you will go a long way to removing surprises and taking back control over a volatile element of your business.

While many importers and exporters still use spreadsheets to manage their foreign exchange risks this is changing. Working remotely has put a spotlight on having a single source of truth, as opposed to sharing an error ridden spreadsheet. There are other risks with using spreadsheets and many of these are well documented.

The treasury management system landscape has also changed in recent times with the move towards more focused, cloud-based apps, such as Hedgebook. Despite having low monthly subscriptions, they can provide all the functionality your business needs to capture, value and report FX hedging (and more).

If you’ve gained something from what you’ve just read, please download the complete FX Risk Management eBook which includes content from this article and quite a bit more.  If you’d like to see how Hedgebook could help you better manage your FX risk – check out our overview video or set up a personalised 20-minute online demo with one of our product experts.

Happy hedging!


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