Top 4 Mistakes That Companies Make in Currency Risk Management
Every business that uses a foreign currency becomes vulnerable to currency rate fluctuations. The rate's ups and downs will impact the business's future worth and its medium and long-term competitiveness.
Businesses can suffer a dead loss if the currency changes to their disadvantage between the time they complete a sale or accept someone's currency and when they cash the payment or pay their supplier. Even the slightest change could have significant consequences on their profitability.
The problem of how to best manage foreign exchange volatility has plagued multinational companies for decades. That's why so many companies are struggling to manage their currency risk in the right way.
In this article, we will talk about four common mistakes that companies make when they manage their currency risk:
1. Not understanding the impact of the exposure to the currency market
If it's the end of the quarter and you need to close the books in a few days, can you adequately explain the exchange rate results to senior management with confidence? A company making some of the previous mistakes listed above would likely be unable to answer "yes" to this question. There is inevitably going to be a mismatch between the underlying exposures and the hedges meant to neutralize them, for several reasons. Intra-month adjustment trades, forecast deviation, mark-to-market calculation errors, forward points, and incorrect and/or catch-up re-measurement entries can all affect your results to various degrees at different times. The ability to quickly isolate these factors is critical in understanding your results and providing a quick feedback loop for your next period's hedging. Attempting to do this without the right tools can be a frustrating exercise and can feel like trying to find a needle in a haystack.
2. Misunderstanding of hedging transactions’ goals and implications
In many cases the company is not fully aware of the purpose of the hedging tool, its payment mechanism and its implications. Over time companies forget why they executed hedging transactions and tend to evaluate their performance as a separate asset that creates profits and losses both economically and from an accounting perspective. This may lead to inadequate transaction cash-flow management (prematurely exercising hedging transactions when profitable) and even to stop hedging when hedging transactions show losses. Some companies choose not to hedge their economic currency risk due to accounting implications.
3. Not having a flexible hedge policy
Many companies that are exposed to currency market movements often have fixed predetermined current practices, and fear of change can be a significant obstacle to updating them. The problem with this is that many things have likely changed since a specific method or risk management policy was established, and various assumptions that may have been true years ago are no longer valid today. Currency risk policies tend to be implemented or updated over time in response to significant losses generated by exposures that weren't previously considered or well understood.
4. Not engaging enough with business partners
If you hedge your company's local currency revenue exposure, do you understand the competitive environment in the various geographies where you do business and their respective specific pricing dynamics? Do you have any pricing power if there is a significant shift in the currency market? Whether your primary exposures are revenue or expense related, several factors would influence how much and for how long you should hedge, whether to use options or forwards, whether to layer in hedge rates, and how to interact with sales/procurement in terms of quoting/purchasing in local currency, and other considerations. A company may also need multiple strategies for differing product lines or business segments. An excellent way to test if a hedging strategy makes sense is to "stress test" it with different "What if?" scenarios, which should include modeling how you and your competition, suppliers, and partners would react.
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