Any company involved in importing or exporting products or services needs to fully understand their foreign exchange risk to ensure it is effectively managed.
Put simply, foreign exchange risk refers to the chance that a fluctuation in an exchange rate will result in a gain or loss for a company.
As we all know, currencies are in a constant state of flux and can shift dramatically in a short space of time, so this is a very real risk. Imagine for example that an exporter receives proceeds from a sale worth USD $1m on 30 September 2002. At that date, that would have translated to NZD $2.1. By 28 February 2003 that same transaction would only translate to NZD $1.8m – a difference of $300,000. In other words, the risks can be substantial, if they are not well managed.
This type of exposure is known as transaction exposure.
Translation exposures relate to foreign currency assets or liabilities, or overseas operations or subsidiaries. For example, if your company has a US$ loan, the NZ$ equivalent balance will fluctuate as a result of net liquidity requirements (e.g. loan draw-downs), and also foreign exchange movements.
The third type of exposure is economic exposure which is a more long term exposure and represents the economic effect on the value of a company from long-term movements in one or more foreign currencies.
For most New Zealand companies, their primary foreign exchange exposure comes through transactions and this is the area that we can focus on understanding and managing better.
The first step to managing a transaction exposure is to make sure that you have a clear picture of how, when and where you have a foreign exchange risk. To do this it is necessary to look closely at every aspect of a transaction.
For example:
- Where and when are your revenues earned? How much time elapses between the confirmation of an order and your revenue being received?
- Are the costs of raw materials tied to the same currency as the sales of your end-product?
- Do you have foreign currency borrowings?
- What are the currencies tax liabilities?
- What is the impact on the balance sheet?
Once you have identified the areas in which you operations are susceptible to foreign exchange risk, the next step is to try to quantify that risk. This is the hard part!
Firstly, you need to ascertain the level of certainty that the transaction will occur before you can take steps to manage the risk it generates. Other areas where you can find this information can include cash flow projections and your budgets or forecasts. When you have a clear picture of where the risks lie and the quantum of your foreign currency exposure, the next question is to determine how aggressively or passively you want to manage those risks. Are you prepared to take a punt and go with the flow of the market, or do you need more certainty as to the foreign exchange rate you will ultimately receive on the transaction?
The options available to you are:
- Ignore the risk – go with the swings and roundabouts of translating your currencies at the spot rate.
- Try to pass through your pricing in NZ $. Chances are your off-shore clients are not going to think this is as good an idea as you do!
- Insert exchange clauses in supply contracts pegged to the NZ$. Once again this is likely to be viewed negatively by potential customers.
- Use foreign currency accounts. If you have payments to make in foreign currencies this provides a natural hedge on the foreign currency sales. However it doesn’t eliminate the translation risk at the end of the month or the financial year.
- Hedge using foreign exchange instruments such as forward foreign exchange contracts (“forwards”) or options.
Essentially, you are faced with two alternatives – to convert foreign currency through a spot transaction (the rate for any given day’s transaction), or to hedge your future transactions with a forward foreign exchange contract. You may of course opt to do both.
What is a forward foreign exchange contract?
This is a contract to buy or sell a foreign currency at a future specified date at a specified forward rate. A forward contract is priced on the current market spot rate with an adjustment made to that rate which accounts for the fact that settlement is delayed for a period. This adjustment basically reflects the difference between the relevant interest rates of the countries involved.
Why use a forward?
A 'forward' contract allows you to mitigate some of the risk you face with a sale denominated in foreign currency. For example, you have a shipment leaving for the US today, but will not receive payment for three months. If you believe that the NZ$ will continue to appreciate faster than that priced in the forward market, your payment in US$ could be worth less in NZ$ than it is now through entering into a forward. So rather than simply wait and see, you can negotiate a forward contract with your bank to confirm the rate of exchange they will give you on any given day in the future based on any given amount. This allows you to tailor your approach and plan ahead, knowing exactly what your cash flow in NZ$ will be.
What you should be aware of
- A 'forward' commits you to making that transaction on a specified day. If your client is late making their payment to you, you will have to enter into a reversing spot transaction on that day in order to complete your forward contract with the bank. This can result in either a gain or loss on the day, and you will still have foreign exchange risk on the underlying transaction, as well as credit risk until payment is received. It is crucial to know with a degree of certainty that your foreign debtors will make the payment on time.
- In entering into a forward, the bank obviously makes a margin. Shopping around to obtain various quotes will get you the best rate.
- A forward will consume a proportion of your credit line with a bank.
- Entering into a forward contract commits you to that rate. If the spot rate is more favourable at that date, you lose the opportunity to exchange your money at that rate.
Overall, foreign exchange risk is only one of many risks that can impact your business in going to the world. Ultimately it is up to you to decide how aggressive or passive you will be in managing this risk. You need to ask yourself …what is worth more… a bird in the hand, or two in the bush?
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