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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.

Thank you for your upload