10 Key Questions Entrepreneurs ask about managing FX Risk

Q1. I have a natural hedge, should I only hedge the residual?

The answer to this depends on the size of your natural hedge:

if you have a large export / import exposure and a relatively small offsetting exposure, then there should be no real risk in managing the residual position
If you have relatively balanced export and import positions, then I recommend that you manage these separately. The primary reason for this is that the timing of your receipts can be unpredictable and the last thing you want is to be forced to buy or sell currency at disadvantageous rates.

Q2. I can’t forecast my cashflows accurately to the day. Does this matter?

This will depend on how you propose to manage your exchange rate risk.

If you are looking to match the hedge with the underlying exposure, then you will need accurate cashflow forecasts.
If you are looking to hedge your overall annual exposures, rather than individual transactions, then you will not require as accurate forecasts

Forecasting can be very difficult as you can never be sure of the timing of your currency receipts. If you find yourself in this position, then a risk management approach that allows you flexibility as to when you use your currency contracts will be the best for you.

Q3. How do I set a Budget Rate?

Budget rates should be set at that rate where your business is profitable.

It can be tempting to look at the historical price action and select a more favourable rate that has traded recently. This can be fraught with danger as there is no guarantee that the price will return to those levels.

However, you can leave too much room between the budget rate and the prevailing market rate and that may negatively impact your competitive advantage.

Q4. We are not currency traders. If we generate profits from our FX activities isn’t that speculating?

To quote Roger Martin from his book The Opposable Mind, innovative thinkers have “the capacity to hold two diametrically opposing idea in their heads. Without panicking or simply settling for one alternative or the other, they’re able to produce a synthesis that is superior to either opposing ideas.”

Electing to manage your risk so that you are protecting your downside while at the same time providing the ability to generate a return from your FX risk management should provide superior results.

Q5. The FX market is so confusing. How do I make my FX management simpler?

This question always makes me laugh.

Speculating is defined as making an investment in the hope of gain but with the risk of loss.

A well thought out currency strategy protects your COGS at the appropriately selected costing / budget rate while still providing the opportunity for gain. So, very little chance for loss.

The payments for COGS occur over time and under changing economic and market conditions. As such you would expect that a prudent currency strategy should also operate over same time horizon rather than a single transaction at a particular point in time.

Q6. I have lost money by not managing my FX risk, What should I do now?

If you have lost money by not managing your FX risk, then design and implement a Risk Management Policy that suits your business and then FOLLOW it.
If you have lost money using risk management products, then the most likely answers are:
- You accumulated products without an overall goal
- You might not have understood the product parameters and outcomes
- Your risk management positions might have been too large for your exposures, giving you no ability to take advantage of the market
- You might have used a product that didn’t fit the prevailing market conditions

Risk management products in and of themselves don’t cause problems. What does cause problems is how they are applied and whether you understand the repercussions if market conditions don’t eventuate as you might have thought.

Q7. Should I hedge if I can’t forecast my cashflows?

Providing you have a reasonable forecast of your cashflows for your BUDGET period, this should not preclude you from managing the risk.

It simply means that you will need to review your position more regularly than if you have an accurate forecasting capability.

For example, you might know that you will need USD 10mio over the next 12 months, but there is some cyclicality to your purchases. After each month,

you would review your purchases and confirm whether the annual figure is still accurate
you would review the market for your product to determine whether there is likely to be any significant event that might alter your forecast
you would make an assessment as to what proportion you want hedged over what time frame depending on your level of uncertainty

Q8. How do I manage a Margin Account so I don’t have to pay a margin?

Normally, margins are set at 5% of the Face Value limit. So, if you have an AUD 10mio limit, then the margin would be AUD 500,000.

If you are exposed to the AUD/USD exchange rate that moves between 10 and 14c each year, and you use your facility to the maximum, then you are likely to be margin called.

To illustrate:

USD exposures of USD 10mio
Budget Rate of 0.7500
Current Hedge Rate of 0.7600
Margin Facility of AUD 10mio, margin call at AUD 500,000

If you fully utilise your limit, you will have USD 7.6mio in hedging at 0.7600.

If the AUD then rallies to 0.8000, then you would be required to pay a margin call.

You will note that this facility doesn’t allow you to be fully hedged (unless the AUD went to 1.0000).

Normally, we recommend that you only put hedging in place up to a maximum of 10x the MTM limit, which in this case would be AUD 5mio.

So, to ensure you have the capability of managing your entire risk, you would likely need a panel of between 2 and 3 counterparties (if all were margin providers).

Q9. How do I know if a recommended product makes sense for me and my business?

I have a few product rules:

If you can’t measure the outcomes, then you should not transact the product
If the product can disappear under certain market conditions, it should not be the only product you are using
If you are likely to get a bad outcome if the market moves your favour, question whether it is appropriate for the current market conditions
If you are given a restructure opportunity, will it give you a better outcome than you already have and what are the additional risks?

Q10. Should I have a Risk Management Policy?

FX risk is often considered a Strategy Risk, that is, it is a type of risk that you voluntarily accept in order to generate superior returns and is therefore not inherently undesirable.

They do, however, require an effective management system that is typically not rules based as this often replaces one risk for another.

An appropriately drafted policy will allow you to:

Consider the risks to your business
Set goals as to what kind of result you desire – protecting your business from loss and generating a return from the FX activities
Set each of the contributors to the result: budget rates, transaction size, maturity horizons, cashflow forecasts, counterparty panel, authorised dealers and the appropriate product suite

This is the basis of your strategy. Once you implement it, you might find that it requires modification, but you will only know that if your FOLLOW your strategy and measure the result.

But in short, yes, I believe every business should have a written Risk Management Strategy document and they should follow it!