“Foreign exchange risk management strategy”

definition

Foreign exchange risk management strategy or FX hedging strategy are terms used to define all the measures devised by businesses or investors to protect the value of their cash flows, assets or liabilities from adverse fluctuations of the exchange rate.

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Market Orders
Forward Contracts
Dynamic Hedging

FX risk management for businesses

These strategies take on special importance for businesses operating across borders, whose costs and/or revenues are in foreign currencies. In these cases, adverse developments in currency markets may increase their costs or reduce their revenues, thereby hurting their financial performance.

We can find a simple example of this by analysing the business model of a European exporter that sells its products in US dollars to US customers. The longer the period of time between each sale, invoice and payment, the more likely the exporter is to be hit by FX volatility.

Currency risk and FX losses

This graph illustrates how variation in the exchange rate might affect companies working with foreign currencies. Applied to the aforementioned example, we can see that the dollar has devaluated against the euro in the time between the European company issuing the invoice (and recognising the cash flow in its books) and the day they receive the payment in dollars from its customer. As a consequence, the exporter will receive fewer euros and the difference will be recorded as an FX loss in its books.

Companies implement strategies to minimise these risks, which usually involve purchasing a financial product to offset their exposed assets or liabilities. There is a wide range of products available for this purpose, the most commonly used of which are forward contracts, options or futures contracts, with different costs and degrees of complexity.

The graph below shows how the exporter could have protected its margins with a forward contract from the invoice date until the payment date:

Risk management and Forward Contracts

Although this strategy is valid for companies with simple currency exposure, it becomes unfeasible for businesses with more complex FX operations or working with a substantial amount of currencies. Kantox’s Dynamic Hedging allows these companies to reduce manual workload in their FX management.

The company only needs to define the key aspects of its FX risk management policy, such as its target exchange rate, risk tolerance levels or maximum volumes of exposure. The software monitors the FX market 24/6 to execute trades when any of the parameters have been met and produces periodic reports with all relevant details about the strategy: open and closed trades, performance, exposure, etc.