What Every Company Should Know About Managing Currency Risk Effectively

If you’re dealing with currency, then you need to consider the problem of currency risk. This applies if you’re making payments across national boundaries, but it’s also salient when you’re operating in one territory, using a single currency.

Of course, the degree to which you’re exposed will depend on where your money is, and how it’s being stored. Let’s take a look at how you might manage your risk.

Identify Your Currency Exposure

To solve the problem of exposure, you’ll need to work out exactly how you’re being exposed. Specifically, it’s worth distinguishing between transaction risk, and translation risk; the former comes about through buying and selling in a given currency, while the latter arises from the consolidation of financial statements into a foreign currency for tax purposes.

If you want to understand the risk in the future, then you’ll need to take forecasting seriously, too. Only by understanding what the future might bring can you make plans to meet it.

Set a Clear FX Policy

The way that you approach foreign exchange should be informed by a specific set of rules. Think about how you might use tolerance bands to manage risk, and how you might restrict the instruments your organisation is allowed to use. By setting the limits clearly, you’ll be able to prevent members of the team from unwittingly taking on board risk. Set the policy out, and make sure that you review it regularly based on the available evidence.

Choose Hedging Instruments Wisely

Hedging is a fundamental way of offsetting risk. For the most part, it’s done with the help of a limited suite of instruments. A forward, for example, might tie two parties into a transaction at a specified future date, and thereby spread transactions over a longer period. An option, on the other hand, might give you the right to exercise a contract, without obliging you to do so.

You’ll also want to align the length of your hedge with that of the exposure – a practice known as tenor matching. This will help to ensure that the hedge actually does its job at the precise moment that the risk materialises. When the two are mismatched, you might end up hedging too much – or too little.

Execute and Record Trades

The way that you record and reconcile transactions should be meticulously standardised. Haphazard records might be more difficult to assess later on. A good risk management adviser might help you to do this effectively.

Monitor and Report Regularly

In order for your hedging to be worthwhile, you’ll need to continually tweak your approach based on the available evidence – and that means measuring what you’ve done, and how it’s affected your performance.