One strategy is just to monitor the changes, and this can be a reasonable option for companies that do not think that they are at a particularly high risk from exchange rate fluctuations.
But a well-defined foreign exchange management strategy should:
- Identify the foreign exchange risk in terms of transaction exposure (arising from the effect rate fluctuations have on payments or receipts in foreign currency), translation exposure (the impact of fluctuations on financial statements) and economic exposure (the impact on future cash flows and market value)
- Quantify the defined foreign exchange exposures at both the subsidiary and parent levels
- Mitigate the exposures through financial and non-financial alternatives
- Evaluate the performance of the risk mitigation effort and look for ways to continuously improve.
The identification stage is crucial and often requires extensive time and effort. The company should identify all areas of foreign exchange risk, reviewing foreign exchange payables and receivables, as well as purchase and sale contracts, leases, etc., for embedded clauses that may require a price adjustment due to changes in exchange rates.
Moving to analysis
Once the exposures have been identified, a company should analyze the potential impact to earnings and cash flow from rate movements. There are numerous techniques to quantify the foreign exchange exposure, from simple sensitivity analysis to sophisticated “value at risk” models. It is important that whatever approach is adopted is supported by management and staff, and the limitations understood by senior management and the board of directors.
Senior management and the board of directors should establish foreign exchange risk tolerances and limits. If the level of risk exceeds the limits, a risk mitigation strategy should be developed and implemented.
There are many financial and non-financial techniques available to mitigate foreign exchange risk, each with pluses and minuses. One example of a financial risk management technique is the use of forward contracts, or agreements to buy or sell at a specified price on a future date.
A popular non-financial mitigation technique is currency invoicing. A company may be able to shift the entire exchange risk to the other party by invoicing its exports in its home currency and insisting that its imports also be invoiced in its home currency.
Many companies initially look to manage their foreign exchange risk by utilizing the non-financial techniques, and subsequently the financial techniques to manage any residual exposures and those where non-financial techniques are not feasible.
Growing a business by expanding the international footprint can be both exciting and stressful. Manage the stress by developing a foreign exchange risk management process that allows you to identify, quantify and mitigate foreign exchange risk, and develop a process to evaluate the success of the program against predetermined benchmarks. This will help ensure company will have a well-thought-out foreign exchange risk management framework and can successfully manage the new global business.
Originally published on The Business Journals website: http://www.bizjournals.com/bizjournals/how-to/growth-strategies/2015/06/foreign-exchange-risk-when-going-global.html