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.

The Currency Risk Management market is opaque and is maintained that way with

• hidden margins;
• the perception of complex products and jargon;
• difficulty in sourcing tailored advice and
• of course, highly challenging and volatile price action.

But the concept of risk management itself is very straight forward:

1. Understand your currency requirements in terms of volume, timing of payments and/or receipts and set your prices
2. Protect your profits / prices when the market moves against you
3. Take advantage of the currency price action when it moves in your favour

Adopting this type of Currency Risk Management programme creates an opportunity to diversify business income streams as well as develop a culture of innovation and business adaptation.

So why do so many businesses simply lock in exchange rates irrespective of what the exchange rate is?

In a word: it’s easy.  But to be fair, often business owners and finance executives don’t have the tools or the time to closely monitor the exchange rate and so the argument is put that locking in the exchange rate completely removes the risk. 

This, of course, is not the case.  The risk still exists. 

In the immediate term it’s now just called opportunity cost and over the medium to long term the exchange rate still has to be addressed every time an order is placed, a payment made or funds received.

With a shortage of expert advice in this area, there is also the view that there is no-one business owners can rely on who will act to keep them informed, so it’s very much a DIY environment.

Having developed risk management frameworks for business leaders for more than 17 years, those that successfully implement a true risk management approach are those business owners with a relentless pursuit towards doing things better, who understand that there is no reward without risk but the greater risk is operating in a changing environment using out of date techniques. In this way they have an unrelenting desire to build a resilient and adaptive business and see challenges as a source of innovation that will allow their business to thrive. 

So, if the concept is straightforward, why is the execution so difficult?  The answer is largely that financial markets tend to be very unforgiving teachers and a successful programme has many moving parts. 

The key elements of a long-term successful Currency Risk Management Programme are:

Over the last 30 years I have met many business owners and finance executives who find currency markets daunting.  Their response is to lock in exchange rates as quickly as possible with little or no consideration of the impact on the business.  This type of behaviour can be highly detrimental to fostering a mindset of innovation as it focusses entirely and only on process.

True innovation requires stopping old behaviours and “unlearning” traditional solutions to consider problems from a new perspective.  Perhaps one of the most dangerous elements of current approaches to managing currency risks is the existing rhetoric that has been used to describe it.  Such long held ideas as:

Create a culture of innovation

• Currency risk can be eradicated using simple hedging products
• Business owners should focus on their core business and leave the currency for the bank to manage
• Profits should only come from core business activities

Comments such as these have become accepted norms over the years as a result of their successful application when the currency was first floated more than 30 years ago.  But with increasing competition and globalisation, these assumptions have become flawed and limiting.

To move beyond this, business owners must apply both a convergent and divergent mindset.  The convergent mindset allows improvement and refinement of the things they know.  Divergent thinking embraces the unknown which helps anticipate what’s next and is the key to adaptation.

Access to expertise

Successful financial markets education is typically mentor based which means that you ordinarily look towards outside expertise.  For decades, domestic banks held this role.  But over time the market has become saturated with new international and regional banks, non-bank product providers and specialised consulting services who typically offer product choices without advice.

When it comes to risk management you might look to incorporate this specific product expertise from a bank or other market participant as well as a specialised consulting service, such as Interfinanz, that can both tailor a risk management framework, incorporate appropriate products as well as oversee the ongoing execution of the programme.

It can be tempting to source advice from “trusted advisors” that might already provide some services to your organisation.  However, developing successful solutions to address currency volatility are likely only to be achieved when a deep understanding of the existing challenges facing the business is combined with an equally profound knowledge of financial markets.  The resulting shared ideas are likely to result in appreciating currency risks from a new perspective.

A learning mindset

The art of adaptation and innovation is not a one-off, full scale immediate transformation.  It is about making incremental changes: addressing changing market and business circumstances regularly and frequently.  It is a learning and iterative environment which is undertaken in a series of small steps.

Over time, this approach is likely to lead to a consciously designed framework tailored to the specifics of the business operations.  Each and every decision will be intentionally formed and become ritualistic to form part of the everyday workflow.  The results can then become part of the broader performance measurements of the employee and business unit.

Key business information

One of the most significant inputs into any currency risk management framework is the actual business variables.  The more precise these are, the more successful the currency risk management programme will be.

Generally, budget exchange rates can be set with reference to the prevailing market.  However, significant exchange rate movements often result in budget rate reviews. If you are operating with a true risk management approach, there is NO NEED to change your budget rates because you will already be taking advantage of favourable market movements or you will be protected from significant negative moves in the exchange rate.

Where there is often some uncertainty, is in the actual volume of the currency requirements both from an annual perspective as well as the weekly / monthly requirements.  This is most evident where fixed currency transactions exist against forecast currency amounts and it turns out that these forecasts are now wrong (a common bi-product of the pandemic where orders dried up; payment terms were renegotiated and supply chains were disrupted).  When it comes to managing the payment profile, flexibility becomes infinitely more important than certainty. 

Performance

Successful and well managed Currency Risk Management Frameworks can serve to provide a sense of purpose for those employees that would typically be considered operational and therefore not profit generating.  Some of the bi-products include:

• A diversified income stream away from the core business
• Improved employee experience by giving traditional cost and operational centres a sense of profit contribution
• Support for the broader employee experience by demonstrating the leadership team’s support of innovative thought and delivery, creating a mindset for change and innovation
• Support for the overall success of the business ensuring consistent customer experience by providing a coherent company structure focused on providing solutions for customers

Adaptability is an essential skill in today’s economic environment, but it’s not without its challenges.  It requires leaders to continuously scrutinise previously successful behaviours and beliefs and assess whether they are still appropriate for the future. 

The pandemic has provided a rare opportunity to make meaningful changes to business practices and to test outcomes when assumptions are reversed. It has also inspired the best leaders to encourage a culture of flexibility, diversity of thought and innovation.

If you would like to discuss ways to apply these principles to your currency risks, we’d love to hear from you.

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.

Quantifiably, risk is usually assessed by considering historical price behaviour and outcomes. In the finance world, standard deviation is a common metric associated with risk Standard Deviation provides a measure of the volatility of a value in comparison to its historical average. A high standard deviation indicates a lot of value volatility and therefore a high degree of risk.

Business owners typically develop risk management strategies to help manage risks associated with their business activities. Measuring and quantifying risk often allows business owners to hedge some risks away by using various strategies including diversification and derivative positions.

Perhaps the most basic (and effective) strategy for minimizing risk is through diversification. Diversification is based heavily on the concepts of correlation and risk. A well-diversified currency portfolio will consist of different hedging structures that have varying degrees of risk and correlation with each other’s returns.

While most investment professionals agree that diversification can’t guarantee against losses, it is the most important component to helping business owners reach long-range financial goals, while minimizing the risk of potential losses.

There are several ways to plan for and ensure adequate diversification including: 

1. Spread your currency portfolio among many different hedging structures. Look for a mix of transactions whose returns haven’t historically moved in the same direction and to the same degree. That way, if part of your currency portfolio is declining in value, the rest may still be increasing;
2. Stay diversified within each type of hedging structure. Include a variety of maturity dates and time horizons;
3. Include structures that vary in risk. You’re not restricted to picking only those structures that provide absolute certainty. In fact, the opposite is true. Picking different hedging structures with different rates of return will ensure that large gains can offset losses;
4. Consider a variety of transaction providers. When one provider does not have a risk appetite for your business or industry another may.

Keep in mind that currency diversification is not a “set and forget” concept.  As business owners perform regular reviews to ensure that their business is operating at an optimal level, so too can this approach be applied to the review of financial risks within the business.  This will necessarily result in a review of the current currency portfolio and may result in the need for it to be rebalanced to ensure that the risk level is consistent with the redefined overall business strategy and goals.

The Bottom Line

We all face risks every day. In the financial world, risk refers to the chance that a financial transaction’s actual return will differ from what is expected – the possibility that it won’t do as well as you’d like, or that you’ll end up losing money.

The most effective way to manage financial risks is through regular risk assessment and diversification. Although diversification won’t ensure gains or guarantee against losses, it does provide the potential to improve returns based on your goals and target level of risk. Finding the right balance between risk and return will help business owners achieve their financial goals through decisions that they can be most comfortable with.

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.

So, this begs the question:

Are all approaches to the management of currency risks appropriate and if not, what does a sound currency risk management strategy look like?  

Ideally, any currency risk management approach should allow you to hope for the best and prepare for the worst.  In our parlance, this is protect your business from unfavourable movements in the exchange rate while allowing it to benefit from favourable ones.

Key to achieving success in this endeavour is to have a comprehensive knowledge of the currency exposure profile with particular emphasis on events that can significantly alter that profile by either making it materially larger or smaller.  This then provides the foundation on which to build the currency strategy.  The more detailed the knowledge of your exposures the more sophisticated your potential currency strategy can be. 

Armed with this information, we can then consider the following:

What is the purpose of our currency risk management strategy?

The answers may not be different from those I suggested above.  You may want:

1. Certainty as to a long-term exchange rate; or
2. Being able to achieve the best rate on the day.

But why not take best of both worlds?  We want our clients to be able to use their currency positions when the hedge rates are better than the current market rates while still being able to use a more favourable spot rate if that is available.  Over the long term, this type of approach will generally result in exchange rates that are superior to a long-term fixed rate and very regularly better than the average spot rates over a medium to long term time frame.

Advantageous currency outcomes and therefore, a sound risk management programme, have a very real role to play in the attainment of a business’s competitive advantage particularly as it can provide an additional revenue source that can support lower product margins or provide cashflow for other uses. In this way, the currency risk management programme contributes to a business’ ability to staying ahead of its competition by providing lower prices or greater benefits and services that justify higher prices.

This should not be confused with speculating on exchange rates with a view to generating a profit stream. Rather our goal is to support the underlying business activities of each client by creating an appropriate risk management strategy such that it that can outperform both fixed rate hedging without sacrificing the opportunities that arise from highly volatile markets. 

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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