How to Avoid the Hidden Credit Risk

Many companies focus solely on exchange rate fluctuations when managing foreign currency exposure. However, a hidden danger lurks beneath the surface: credit risk. This blog explores how embracing currencies and taking ownership of FX risk can mitigate this often-overlooked threat.

When working with foreign currencies, CFOs and treasurers have the mission to reduce FX risk as much as possible. But they could be overlooking an underlying type of risk: credit risk. In a recent episode of CurrencyCast, we shared the secret to mitigating credit risk. Now, we will explain in detail the key actions you need to take to avoid this hidden risk.

Understanding credit risk in currency management

Credit risk or, more precisely, the risk in account receivables appears when customers need to settle their bills in a different currency than their own and the possibility that a person or organisation will default on their loan repayments. Defining credit risk is key to calculating the interest rate on a loan. The longer the repayment period and the lower the borrower’s credit rating, the more expensive the interest rate.

Counterparty credit risk is the risk that the other party to an agreement, bond, investment or trade will be unable to repay their debt or comply with their obligations.In corporate FX management, credit risk is a relevant aspect for forward contracts when one of the companies involved applies hedge accounting standards, as the counterparty credit risk is one of the factors used to determine the fair value of the hedging instrument.

This underlying currency risk can easily be eliminated by following a simple rule in your currency management strategy, embracing currencies. But, what do we mean by embracing currencies?

Imagine using your customers' and suppliers' native currencies. This creates a smoother business experience and prevents their FX risk from becoming your credit risk. Think of it like speaking their language – it fosters trust and eliminates communication hurdles. It makes business a lot easier and helps you to avoid your client’s FX risk from turning into your own credit risk.

Uncovering the underlying credit risk

Companies selling in emerging markets with a single currency (like USD or EUR) may believe they've eliminated FX risk. However, this is an illusion the underlying currency risk is still very much there.

By forcing customers to use a foreign currency, you inadvertently transfer the risk to them. A sharp local currency devaluation could incentivise them to delay payments. In other words, your customers would speculate in FX markets with your firm’s money. This phenomenon has been observed in recent years, particularly in Latin America and Eastern Europe.

As a treasurer or CFO, you don’t want to be in that position.

Taking ownership of credit risk

To avoid your client’s FX risk from turning into your own credit risk, the solution is simple: sell in your customers' currency and manage the underlying FX risk. This requires a robust, automated currency cash flow hedging program. These programs can include:

• Hedging individual sales/purchase orders as they arise.
• Hedging forecasted exposures for specific campaigns or budget periods.
• Combining these strategies with tools that provide continuous exposure visibility.

The unexpected benefits

Now that we understand the importance of credit risk, let's explore the advantages of taking ownership of FX risk:

• Capital protection. You are protecting your firm’s capital against catastrophic loss while managing reputational risk simultaneously.
• Cost of capital. You are reducing the cost of trade credit insurance if you use it, slashing lousy debt reserves and freeing up capital.
• Performance. You are securing company earnings while maintaining cash flow.
• Commercial expansion. You are in a position to expand sales with confidence, gaining market share and/or targeting new customers.

Finding a solution to mitigate the risk efficiently

For companies ready to embrace currencies, a currency management automation solution holds the key. These tools streamline your strategy and automate your FX workflow, mitigating not only exchange rate risk but also the often-hidden credit risk.

In today's multi-currency world, companies can capitalise on the benefits of selling in multiple currencies. This includes monetising existing FX markups and driving high-margin sales through company websites.

Automation makes managing the underlying FX risk a smooth process, outweighing any perceived inconveniences. Additionally, in today's uncertain environment, you gain the valuable benefit of reduced credit risk in your commercial operations – a significant advantage!

By embracing currencies and taking ownership of FX risk, you can protect your capital, streamline your workflow, and achieve long-term success in the global marketplace.

Thanks to automation, these advantages far outweigh the perceived inconveniences and costs of managing the underlying FX risk. And, in the current scenario of uncertainty, you get an additional and very attractive bonus: less credit risk in your commercial operations. That’s quite a lot!

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