FX gains and losses series: Playing Russian roulette with unhedged exposure

From the accounting department all the way up to the C-suite, FX gains and losses on the income statement represent one of the principal concerns for international business.  This focus is not without its merits: foreign currency gains and losses can erode otherwise-reliable profit margins. Perhaps more telling, though, is that these uncontrolled movements signal the mismanagement of FX risks.

In an era of increasing global competitiveness, exchange rate risk can be a significant advantage – if properly managed.  If not, though, inattention to the impacts of FX exposure can wreak havoc on the balance sheet.

We put together a series of articles to provide CFOs and treasurers with a complete overview of exchange rate risks. Inside, we will explore the most common sources of FX gains and losses, clarify widespread misunderstandings and offer techniques and tools to mitigate their impacts.

Although it might seem like common sense, it is surprising to see how even the largest international companies may underestimate the risk of a simple formula present in every foreign currency transaction: the difference between the FX transaction recorded and the FX transaction settled generates currency-related gains and losses.

Let's start with understanding how unhedged exposure impacts your balance sheet generating FX losses. Then we will give you some tips to improve the efficiency of FX risk hedging.‍

FX losses from unhedged exposure

In the graph above, we observe a clear example of an EU business working with euros invoicing a services sale worth 100,000 USD and receiving payment on the settlement date.  Between the two events, the euro appreciated 2% against the dollar.If the company did not hedge their exposure, they would be registering a 2.0% FX loss for that particular transaction.  

2.0% might not be a lot on its own, but looking at it in comparison to the profit margin tells a different story: if the company expects to take 10% profit on the sale, an FX loss of 2% equals a 20% decrease in profit.  

If their margin is only 5%, then the impact is even greater, with 40% of their expected profits disappearing into thin air. A setback of these proportions in one of the firm's strategic business lines would inevitably raise concerns at the management level.

The impact of not hedging FX risk

In spite of the obvious consequences, a 2016 study of U.S. businesses by Wells Fargo found that 36% of them do not have a formal policy in place to address FX risk. One-third of that 36% claim that their commercial activities and cash flows are difficult to forecast, and therefore, pre-hedging those sales is a troublesome issue that might increase costs without guaranteeing adequate coverage of the FX risks.

According to a survey by Deloitte, another frequent problem for many treasurers and CFOs is their general lack of knowledge and resources to identify FX exposure and set out an effective hedging program. However, the main reasons why companies leave their profit margins exposed to FX risk is a mix of both symptoms: a trouble to find the right moment to hedge and the lack of ability to choose the appropriate strategy to do so.

How to improve efficiency in managing risk-driven hedges

It is true that banks and traditional brokers often cast a veil of opacity over FX operations and currency hedging products, in particular.  This is often just a scheme to apply abusive and mostly hidden fees to the 'hedger.' Over the past few years, though, technological developments applied to financial instruments have brought forward more transparent players and straightforward tools to simplify and improve efficiency in managing risk-driven hedges:

• ‍Pre-hedging is not necessary: FX technology allows your company to set up a micro-hedging strategy consisting in automatically executing hedging instruments for the value of each sale or purchase agreement or, in case of multiple small sales, bundling total volume of the daily accumulated exposure, with a hedging instrument maturing at the payment date.
• ‍You do not need in-depth FX knowledge: You just need to define your target exchange rate and the percentage of risk that you are willing to tolerate. Dynamic Hedging technology connects to your company’s ERP or sales platform via API and monitors FX market movements along with your firm's accumulated exposure to execute hedging operations according to your risk parameters. After executing the hedging instrument, your exposure drops to zero.‍
• Minimising FX gains/loss with micro-hedging

The challenges to keep FX gains and losses under control should not be an excuse for complacency when it comes to foreign exchange risk.There are tools readily available offering flexible solutions to approach FX risk management from every angle and adaptable to practically every commercial cycle that monitors exposure and hedges risk from its inception to the very moment of the foreign currency conversion...which we'll explain in the next article: Unhedged conversions

‍

Updated: 26/09/2024