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:

  1. 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
  2. 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.

  1. If you are looking to match the hedge with the underlying exposure, then you will need accurate cashflow forecasts.
  2. 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?

There is no doubt that FX markets are complex and can appear confusing.  The way to address this is to build a risk management strategy that suits your business activities and risk profile.  But then you must FOLLOW it.

It should include:

  1. Cash Flow projections
  2. Budget Rates
  3. The percentage to be hedged
  4. Transaction sizes
  5. Product Suite
  6. Dealing Authorities
  7. Counterparty Panels

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

  1. 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.
  2. 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,

  1. you would review your purchases and confirm whether the annual figure is still accurate
  2. you would review the market for your product to determine whether there is likely to be any significant event that might alter your forecast
  3. 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:

  1. USD exposures of USD 10mio
  2. Budget Rate of 0.7500
  3. Current Hedge Rate of 0.7600
  4. 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:

  1. If you can’t measure the outcomes, then you should not transact the product
  2. If the product can disappear under certain market conditions, it should not be the only product you are using
  3. 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
  4. 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:

  1. Consider the risks to your business
  2. Set goals as to what kind of result you desire – protecting your business from loss and generating a return from the FX activities
  3. 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!


How to Avoid the Most Common Pitfalls when Managing Currency Risk

Who is this guide for?

  • Business owners considering expanding into offshore markets
  • Business owners who already buy or sell in international markets and have lost money
  • Business owners / CFOs who lie awake at night worrying about currency movements and their profit impact

International markets can provide exponential growth for businesses by way of broadening either the supplier or customer base.

But the increase in risks can also be substantial because now your profits are exposed to a highly volatile and seemingly uncontrollable force: the exchange rate.

The AUD/USD typically trades in a 14c range each year. 

Of course, 2020 being an extraordinary year on most fronts, it also saw the AUD/USD trade in a 38c range.

On December 31, 2019, the AUD traded at a high of 0.7032 before collapsing to 0.5509 on March 19 and then retracing to 0.8007 on February 25 2021. Daunting price action in anyone’s language.

While we don’t get 30c moves every year, we do see 14 -20c moves each year, so how do you avoid letting this impact your profit margins?

Let’s look at the most common pitfalls facing business owners when dealing with the currency.

Most of the pitfalls detailed below arise from the following:

Top 5 Pitfalls Most Businesses Make when dealing with Currency Risks

  • Not understanding your own risk preferences
  • Not fully understanding your cashflow or payment schedule
  • Considering the currency as an after thought
Pitfall 1: Disconnect between currency purchases and requirements

Understanding your cash flows is generally relatively straight forward. 

The difficulty arises when expanding into the international markets as this takes time.

As a result, there are often lumpy international payments or receipts.  If you are making foreign currency payments, you at least have some control as to the timing. Bear in mind though, that if you delay payments until you get a “good” rate, you risk alienating your new supplier.

Selling to international markets is somewhat more problematic.  You are now at the mercy of your customer as to when they pay as well as when the bank finally transfers the funds to your account.

A word of warning to recipients of foreign currency funds: banks will often automatically convert foreign currency into AUD at retail rates.  So, you will have no control over the rate at which the funds are converted.  You will need to make sure you have a “Do not convert” instruction in place.

Pitfall 2: Reacting to market price action (Speculating)

Speculating is perhaps the most dangerous of all the pitfalls and it can come in two forms.

The first is epitomised by the concept of a “good” exchange rate.

The first question is good compared to what?…yesterday’s rate, the rate you got last time you made a payment, better than what the forecasters predicted? 

The only thing that really matters is that it is better than the rate you have used to set your selling price or your budget or target rate.

If it’s not, then you have eroded some of your profit margin.

The second type of speculating occurs when you think the market is going to move against you and you start taking large positions. 

If the market does collapse, then you might call it risk management but it is really luck. 

Of course, if the market moves in the opposite direction then you have a large amount of currency to use up. 

If you haven’t matched it against your cashflows, you may find that you have given up considerable profit opportunities to protect the risk of a downward movement or worse, you have more currency than you need.

Pitfall 3: Measuring your payment rates against the spot rate

This follows on from Pitfall Two.

And it generally happens when there have been large single directional currency moves (also known as impulsive moves).

Rather than benchmark against your budget rate, you want to budget against the spot rate.

Three things happen here. 

First, you are not measuring your profit accurately.  If you have set a rate to determine your selling price, then any rate that is better than that is an increase in profit margin and vice versa.

Second, if you find that the spot rate is better than rate you booked some time ago, your will likely move towards Pitfall 2 and start buying when the rate is “good”.

The third thing that happens is complacency.  If you fell that you are doing better by “picking the market” then you won’t be ready for the turn, which in currency markets is inevitable.

Pitfall 4: Confusing Factual Information with Advice

In the main, it is almost impossible to get specific advice tailored for your business from banks or brokers.  There is usually a General Advice disclaimer either before you start talking with them or after. 

This means they are not taking your specific requirements into consideration.  It might feel like they are, but they are not.

So, it is up to you to evaluate the risks and benefits of the information they provide. 

Pitfall 5: Counterparty Diversification

Counterparty diversification is often overlooked and generally for a couple of reasons.

First, it’s easy to deal with only one bank or broker.

And two, many businesses still hold to the idea of building relationships with their suppliers, whether it’s a bank or any other supplier.

However, using only one counterparty has the following drawbacks:

  • It leaves you open to a change of heart by your bank which means you would have to either close your FX positions or move them
  • If you wish to change to another bank or broker, you have to close or move your FX positions
  • If your business grows substantially, you might run out of available limit and so can only buy in the spot market

Of course, if you have only small requirements, then it probably doesn’t make any sense to have more than 1 counterparty, but as your business grows, it’s another risk to be considered.

Each of these pitfalls can be easily avoided.  With a tailored risk management programme all the critical elements of your currency risk can be addressed, leaving you to focus on the growth of your business.

What’s the next step?

If this article has piqued your curiosity and you’re keen to explore further, then the next step is to set up a time to conduct a complimentary Currency Risk Management Overview session, either by digitally or in person.

We’ll review and evaluate your risk profile as well as your current risk management approach and work with you collaboratively to create a plan to manage your currency exposure(s).

If you enjoy the conversation and find it worthwhile, we can discuss working together.

On the other hand, if what we come up with isn’t quite what you were hoping for or you feel we are not best placed to assist you with your currency requirements, then that’s okay too – at least you’ve looked at what else is available.

To take the next step, call us on (03) 9415 7353 or complete the Contact Form:

https://www.interfinanz.com.au/contact/

Whatever you do, I hope that some of the ideas in this guide help you to understand and manage your exchange rate risk more effectively.


How to Build an Effective FX Risk Management Programme

Who is this guide for?
  • Business owners who source their product from offshore markets
  • Business owners who sell into international markets
  • Entrepreneurs who are looking to expand into international markets
  • CFOs working in businesses that deal in international markets
  • Accountants looking to assist their business clients

The most successful businesses are those that operate as part of the global economy, whether it’s sourcing or selling goods or services to foreign markets.

While expanding your customer or supplier base internationally can help supercharge your earnings, it also comes with some global size risks: most notably, the exchange rate.

At the last Triennial Central Bank Survey released in April 2019, trading in FX markets had reached USD 6.6 trillion per day.

In Australia, FX turnover averaged USD 119 billion per day an increase of 6% since 2016.  Of this, more than 97% is associated with speculative trading activities.

So, you might say, that the AUD is being controlled by offshore speculators and traders.

The following material shares some of the most significant things we have learnt about managing currency risk over the last 20 years.

First, let’s look at the challenges faced by business owners, entrepreneurs and CFOs when dealing with exchange rate risk.

Top 5 Challenges Faced by Business Owners and Entrepreneurs when dealing with the exchange rate

Most of the challenges faced by businesses transacting in the global economy are by-products of the following factors:

  • Highly volatile price action
  • A plethora of available and often contradictory information
  • A focus (and often love) of the core business activity taking up almost all of their time
  • A lack of understanding and enthusiasm for currency markets

These elements often create an aversion to spending any significant time dealing with exchange rate issues. 

More specifically, there are 6 issues that are relatively common in growth focused, entrepreneurial companies:

Challenge 1: Understand your Risk Profile

Most entrepreneurs are exceptional business people and eternal optimists.

This means that focusing on risks, especially highly volatile moving risks, can feel uncomfortable at the very least or result in avoidance altogether.

Typically, this means that it’s only after a currency collapse or crisis that currency risk becomes important.  By then it’s caused enough financial distress and worry to keep you lying awake at night.

Understanding your response to the currency is an important step in how you can tackle the risks it poses going forward before it impacts your business.

Challenge 2: Time Scarcity

Building a business is very time consuming.

Ensuring the quality of your offering, building your brand, identifying your target market, addressing the logistics of getting it to your customers, setting prices and dealing with suppliers and staff. It all takes time.

While you focus on the day-to-day running of your business, it can be very tempting to regard the currency as an afterthought and only deal with it when it becomes absolutely necessary.

Challenge 3: Uncertainty around foreign currency payments / receipts

When you first start dealing in the international market, your foreign currency requirements are often lumpy and very difficult to project.

This tends to support the idea that you can deal with the currency when it becomes absolutely necessary while you focus on building your business.

The problem with this approach is that you don’t consider the following question: at what point does managing the currency risk become an important component of contributing to profit growth and margin?

Challenge 4: Basing Decisions on Forecasts

As your foreign currency requirements become more predictable the idea that perhaps more attention should be focused on the exchange rate starts to become clearer.

So, you might look to build a better understanding of currency movements and you might start with bank or broker forecasts of the direction of the exchange rate.

You might remember I said that more than 97% of currency price action is speculative meaning that less than 3% has any true economic backing.

If you are relying on economists’ forecasts, how do you know they are considering all the elements that make up the market. 

Perhaps, more importantly, it doesn’t really matter to forecasters whether they are right or not.  If they are wrong, they will simply issue new forecasts and seek to explain what happened after the fact.

Challenge 5: Too much Information

The next problem could be considered part of the previous challenge. 

Everyone has an opinion about currency markets, from taxi drivers to currency dealers and bank managers.

Information is available from the nightly news, through email subscription lists and of course every bank and broker has their own commentary and economic view.

Invariably, you can receive information suggesting completely contrary views with valid supporting explanations, leaving you more confused than before you started your research.

How Do Most Businesses Undertake Their Currency Risk Management?

Most businesses use one of three methods:

1. Buy when required

This is the most straightforward method and works particularly well if the market is moving in your favour.

It does expose profit margins to extreme fluctuations when big price moves occur.

It can also slowly erode profit margins if negative currency movements occur over long periods and selling prices can’t be adjusted.

2. Rely on their bank / broker for products and information

This is perhaps the most common approach. 

Businesses purchase their currency from a bank or broker and rely on the sales team to recommend the best time to buy as well as the best hedging products. 

Don’t get me wrong, understanding the difference between FECs and options is very important, and often some insight can be better than none. 

The drawback is that banks and brokers will often sell you a product that is best for them, rather than what might be best for you.

3. Buy when the rate is “good”

If I had a dollar, for every time I have heard this phrase, I would be a very rich woman indeed.

This is the approach where a policy often exists with a requirement to buy a certain amount of currency to ensure a certain percentage hedge level. 

Everything starts off well, and the policy is adhered to and then, all of a sudden, the market starts to move favourably and the purchases begin to be made on the basis of whether the rate is “good”.

This is when the policy parameters go out the window, and more currency is bought at the so called “good” rates. 

By the afternoon or next morning, the market has continued its trajectory and now the rates don’t look so good anymore and you find yourself with too much currency.

4. Tailored Risk Management Policy

And then there’s the tailored risk management policy approach.

This has some extremely important features:

  • It’s designed to address specific currency risks for each business
  • It’s highly measurable and accountable
  • It designed on the basis that currency markets are highly volatile
  • It’s designed to protect and grow profit margins

Having said that, it’s one thing to design a tailored risk management programme.  It’s quite something else to implement it. 

This approach requires both a time commitment and knowledge of both the available suite of currency tools as well as market price action.

But perhaps most importantly. it requires the discipline and objectivity to continue to adhere to the programme.

Characteristics of Super-Successful Currency Risk Management Programmes

The following outlines the key elements of an effective risk management programme.

Element 1: Set the Goal(s)

In currency markets there seems to be a belief that there is only one type of risk, and that is the risk of losing money on a currency move.

But the flipside is just as important:  the profit growth you miss out on if you act at the wrong time.

So, the question becomes: do you care if you miss out on profits?

If the answer is yes, your goal needs to be set to ensure you protect and grow profits.

Element 2: Understand and model your cashflow projections and set an appropriate target rate

Arguably, this is the most important piece of the puzzle – if you get this wrong, all your currency decisions will also be entirely inappropriate. 

Spend time and energy understanding your cashflows and payment schedules.

Then set the budget rate.  This is the KPI or metric of your risk management programme and should be one of the inputs in setting your selling price.

Element 3: Develop a set of rules and following them

Define and articulate how you will implement your programme that makes sense in the context of your business.  Some of the things that should be included are:

  • The maturity profile;
  • The percentage to be hedged;
  • The transaction size;
  • The budget rate;
  • The product suite;
  • The counterparty list and how it will be spread;
  • The payment process;
  • How regularly it will be reviewed;
  • Who will be authorised to transact.

There can be a lot of moving parts to manage – too many to discuss here.  We have a number of guides that might help you to navigate these decisions.

Implementation Approaches

So far, we have looked at the hedging and currency risk management approaches that are available to entrepreneurial businesses from quite an esoteric perspective.

But of course, the most important question is, how do you implement any of these strategies?

Option 1:  Do it yourself

As an owner, you might consider it your responsibility to deal with risks to the bottom line. 

If you have plenty of time and desire to learn about financial markets and hedging products and you have the inclination to watch the price action more than just on the nightly news, I would suggest having a go yourself.

But, and it’s a big but, there is likely to be a lot of trial and error. 

Currency risk management is both an art and a science. 

What does that mean? It means experience matters.  So, if you are happy to tread carefully, realise that sometimes you will make errors of judgement and it will cost you money, then doing it yourself might be a good option.

Option 2: Hire internally and Make it the responsibility of your CFO

Bringing in additional resources will free up your time to run the parts of the business you love.  However, you’re most likely going to want a new CFO to address a broader range of financial responsibilities. 

With a recent survey suggesting that 58% of CFOs consider that FX risk management is one of the two risks that occupy the largest proportion of their time, it might just be that you’re transferring your time scarcity to them.

It’s also possible that while they have had some experience in FX in a previous organisation, that experience might not be relevant to the specifics of your business. 

So, hiring in house might simply transfer the stress and time commitment to another member of your team without getting any overall improvement.

Option 3: Hire a consulting group

Option 3 is to hire a consulting group such as Interfinanz to take care of these risks for you. 

Every consulting approach is different, but in the case of Interfinanz, we give you access to professionals that have spent more than 20 years observing, understanding and specialising in financial markets and currency risks in particular.

Applying that knowledge to your business, we will design a detailed risk management programme tailored to the specifics of your business and collaborate with you to ensure its seamless implementation.

With all the critical components of your risk management addressed, you can focus your time and energy towards working on your business rather than in it.

What’s the Next Step?

If this article has piqued your curiosity and you’re keen to explore further, then the next step is to set up a time to conduct a complimentary Currency Risk Management Overview session, either by digitally or in person.

We’ll review and evaluate your risk profile as well as your current risk management approach and work with you collaboratively to create a plan to manage your currency exposure(s).

If you enjoy the conversation and find it worthwhile, we can discuss working together.

On the other hand, if what we come up with isn’t quite what you were hoping for or you feel we are not best placed to assist you with your currency requirements, then that’s okay too – at least you’ve looked at what else is available.

To take the next step, call us on (03) 9415 7353 or complete the Contact Form:

https://www.interfinanz.com.au/contact/

Whatever you do, I hope that some of the ideas in this guide help you to understand and manage your exchange rate risk more effectively.


Currency Risk Management: an alternative income stream for business?

Currency Risk Management, real Currency Risk Management, has the reputation of being a complex part of any business.  Like most business challenges significant opportunities exist from complexity.  In this instance it is the ability to generate an additional income stream.

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Currency Risk Management and Diversification

Every business owner is exposed to some type of risk in their everyday life – whether it’s from driving, walking down the street, selecting stock lines or something else. A business owner’s personality, lifestyle, age and business experience are among the key factors to consider for individual risk purposes. Consequently, each business owner has a unique risk profile that determines their willingness and ability to withstand currency fluctuations. In general, as perceived financial risks rise, greater returns are expected to compensate for taking those risks.

Read more…

Currency Risk Management for Competitive Advantage

There are many ways to manage currency exposures.  Some give you long term fixed rate outcomes so that your business has complete certainty as to the exchange rate.  Other approaches simply take the prevailing rate of the day with the hope that if the market moves adversely, this can be either absorbed into profit margins or passed on to consumers.

Read more…

Measuring Your Currency Risk Management Portfolio

When you commence a risk management portfolio, it’s important to remember that you are making decisions for both the short and medium term.  In most instances, the objective is to attain certainty regarding your currency requirements as well as the attainment of a particular exchange rate level on an annual basis.

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How Important is Collaboration with Your Financial Advisor?

Much has been written about the role of a Financial Advisor. ASIC have suggested that:

Consumers who seek financial advice expect their advisor will act in their best interests and that the advice provided will leave them in a better position. (RG 175.244)

When assessing whether an advice provider has complied with the best interest duty [consideration will be given to] whether a reasonable advice provider would believe that the client is likely to be in a better position if the client follows the advice. RG 175.245)

But what does this mean in practice?

Read more…

What is Tailored Financial Advice?

Tailored financial advice is to the financial services industry what Haute Couture is to women’s fashion and a bespoke suit is to men’s fashion.

To illustrate, let’s consider a suit. A suit can be bought for a man or a woman. It can be bought off the rack from a department store or it can be made to your own exacting specifications and body shape.

Read more…

The Business of Currency Risk Management – Focusing on Risk and Return

While there is nothing wrong with only focusing on protecting against currency losses. In the current highly competitive environment, there are those who are only focusing on maximizing profits. These are the companies that typically hedge everything with a set and forget strategy when the market is moving against them, or don’t hedge at all when the market is moving in their favour.

Read more…
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