How to formulate a currency risk policy
Forex market is complex and trying to understand the movements are difficult even for specialists. If the company has no real experience in forex market it makes sense to outsource or even get a consultant to evaluate the business process to see where currency risk is accrued and what can be done to reduce or negate such risk. This needs to be done proactively and evaluated at regular intervals to ensure risk is mitigated correctly in line with the companies risk profile.
You need to consider the following factors, before deciding when and how to hedge your foreign exchange risk.
Do you have a clear overall understanding of your own company’s foreign exchange exposure?
What portion of your foreign exchange risk can be offset naturally? And is it in your interest to do so?
Will shareholders benefit from hedging your exposure?
Are there risks which it is not possible to hedge? For example, royalties or dividends?
Answering these questions will help to define the objectives of your hedging strategy. The primary objective of a currency risk management strategy is to protect the economic value of a business. Secondary to this is striking a balance between risk and return.
Too many companies do not fully understand the complexity of the underlying risks they face. They focus on isolated aspects when making hedging decisions, thereby falling short of the total business objectives. An in-depth risk profile that incorporates direct and indirect risks, shareholders expectations, corporate governance and best practice as well as possible outcomes can help overcome this problem.
The next step is to develop a risk management policy framework that quantifies the risk through a benchmarking process that specifies the benchmark rate, (either a forward exchange rate or a ruling spot rate when goods land), the hedging instruments used, and the trading disciplines employed. In addition it should define areas of accountability and responsibility with a clear separation of duties.
Many corporations do not benchmark their treasury operations and are therefore not able to quantify the value these operations add. Simply improving a portfolio against an agreed benchmark rate may not be enough if the result is, for instance, to lose market share. A more sophisticated approach involves a risk adjusted return analysis which can help a company beat the benchmark rate and gain competitive advantage, outperform the market on average, and stay in the market.
Most recently and notably, the failure by the advanced economies to understand their risk/reward profile or to manage their risk adequately has brought about the state of financial turmoil facing the world.
When developing a risk management policy it is important to define your objectives
The primary goal of currency risk management is to protect the economic value of a business from exchange rate fluctuations.
The secondary goal should be to strike a balance between risk and return because of the volatility of exchange rates.
Volatile exchange rates can have a significant impact on the earnings, cash flows and profitability of a company. Effective management of foreign currency risk can help stabilise a company’s performance relative to currency markets and is a source of competitive advantage.
Formulate risk profile
Shareholders expectations
Accounting vs. Economic Risk
Financial vs. Market Risk
Competitors / Industry
Profile of product/service (price elasticity /seasonal /cyclical)
Direct Risk vs. Indirect Risk
Corporate Governance
Develop Risk Management Policy
Primary goal of currency risk management is to protect economic value of a business from exchange rate fluctuations.
Secondary goal should be to strike a balance between risk and return
Objectives should be measurable
Quantify risk through benchmarking
Establish accountability and responsibility
Hedging instruments
Trading disciplines
Financial and Management Reporting
Establish Risk Management Committee
Measure performance
Determine if the objectives have been achieved
Suggest corrective actions
Be aware of changing markets and environment
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