Why a strategy is vital for reducing FX risks and costs
Understanding foreign exchange (FX) risk is essential for business leaders to avoid unforeseen costs that could cripple a firm, but the task of developing a strategy is complex and potentially costly.
According to the Association of Chartered Certified Accounts, small and medium-sized businesses (SMEs) that operate across borders are significantly exposed to fluctuations in the exchange rate.
“Frustrated by complexity and cost, and with only limited resources and access to relevant skills, some SMEs may be resorting to overly expensive hedging methods or taking their chances without hedging,” said the report.
Too much hedging or too little; either way it’s a problem for the SME owner, whose experience of FX risk is usually limited.
Measuring and managing exchange rate risk exposure is essential to reduce vulnerabilities from major exchange rate movements, which could adversely affect profit margins and the value of assets.
But it’s not an easy task to develop a strategy. For starters, SME owners need to understand the difference between transaction risk, translation risk and economic risk. This is merely the start of the process that can be simply too much for most.
“Selecting the appropriate hedging strategy is often a daunting task due to the complexities involved in measuring accurately current risk exposure and deciding on the appropriate degree of risk exposure that ought to be covered,” writes Michael Papaioannou in a research paper from the International Monetary Fund (IMF).
Moreover, he notes that even after identifying the types of exchange rate risk and measuring the associated risk exposure, a firm needs to decide whether to hedge or not.
A comprehensive strategy is a necessity, and businesses are turning to currency specialists to develop bespoke systems to mitigate the effect of currency movements. As specialists have the expertise to produce the kind of tailor-made strategy that a firm needs, they are often seen as better placed to help SMEs than banks.
The strategy should include specifying the firm’s currency hedging objectives, which ought to consider if the firm should fully or partially hedge its currency exposures.
It must also include a detailed currency hedging approach. “It is imperative that a firm details the overall currency risk management strategy on the operational level, including the execution process of currency hedging, the hedging instruments to be used, and the monitoring procedures of currency hedges,” the IMF paper explains.
There is no silver bullet or one-size-fits-all solution, which makes it all the more important for businesses to develop a tailored strategy that suits their own complex needs.