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Running a business involves a lot of risk management. A thorough understanding of the various threats a company may face and the development of comprehensive strategies to prevent or mitigate those threats is essential to effective risk management.

Foreign exchange risk arises whenever a company does business internationally, whether it is shipping or receiving goods, paying employees, or selling across borders. When the value of their currency fluctuates, they are exposed to financial loss. As a result, forex risk management strategies are frequently leveraged.

 

A hedging strategy, cross-border payment platforms, and working with a forex agency are all options for some people. For others, it means partnering with a forex agency to handle their international payments.

A company's forex risk management strategy is unique, but some common mistakes are made when it comes to protecting itself from foreign exchange risk. Here are 10 things to avoid when developing a forex risk management strategy:


Maintaining the current state of affairs


There is a lot of inertia in many businesses and forex agencies' current practices. Fear of change can be a major roadblock in the forex market and the global economy as a whole. It's easy to get sucked into the idea that "because we've always done it this way" is a safe place to stay. There is a problem with this because many things have changed since a particular practice was established, and various assumptions that may have been true many years ago are no longer true today.

When significant FX losses are caused by exposures that weren't previously considered or understood, new FX policies are developed and/or updated over time as a result of those changes. Waiting to implement the proper FX risk management processes and procedures until after a significant FX loss occurs is like waiting for your house to burn down before purchasing insurance. Learn from the mistakes of others and seek qualified help if you want to be a world-class FX organization.

 

Analysis and recalibration play a critical role in managing foreign exchange risk. The strategy of a business must be constantly re-evaluated and adapted to the results.

 

Understanding Currencies' Long-Term Trends


In the context of hedging strategies, do you or your business partners consider currency views? To get an accurate forecast of the currency rate in a year, it's best to ask five different banks. The average of their forecasts will be close to the spot rate.

It's more likely to be a contrarian indicator than a good forecast if the banks all agree on the same direction of travel. Hedging programs should not be affected by current market trends or directional views at all.

 

A hedging program is frequently terminated because it is "losing money" just as the underlying exposure begins to lose value and the hedges (now nonexistent) would have had offsetting gains. It is important to consider both the underlying exposure and the hedge to determine the success of a hedging strategy. Ineffective risk management is based on guessing what will happen on just one side of the equation.

When it comes to managing foreign exchange risk, it's important to realize that nothing is safe. Knowledge, experience, constant analysis, and agility are the most important tools for building a comprehensive strategy.

 

Not "Stress-Testing" Your Plan


What is your understanding of the competitive environment in the various countries where your company does business, as well as specific pricing dynamics? In the event of a significant change in FX rates, do you have any pricing clout?

Optional or forward contracts, layering hedge rates, interacting with sales/procurement to quote/purchase in local currency, and other factors all influence the amount of money you should hedge and how long you should wait before doing so. If a company has a variety of product lines or businesses, it may need a variety of strategies.

 

A good way to "stress test" a hedging strategy is to simulate various "What if?" scenarios, including how you and your competitors, suppliers, and/or partners would respond to each scenario. Your currency hedging strategy may need to be tweaked if you can't live with the results of a significant currency shock in either direction.

 

Having a fear of tying oneself to a loss


Balance sheet hedging is a common cause of this issue. Imagine that a week after you set your monthly accounting rate, your business receives new information on exposure. An outright forward should be entered into to adjust your hedge based on the nature of this information. Nonetheless, if the currency has shifted against you, the adjustment hedge will lock in a profit.

 

An excuse like "our forecasts never turn out to be accurate" is often used to avoid locking in a loss in this situation. To manage risk effectively, an FX policy must be in place that removes the emotions from risk management (i.e. if the exposure is above a certain threshold, it is hedged—period). A week's worth of bad volatility can turn into a month's worth of even worse volatility because volatility is a function of time. In the end, "hope" isn't an option. Hedge if you have a significant risk.

 

To protect yourself and even make money in the long run, hedging requires foresight, and sometimes a short-term loss is worth it.

 

Preparing a Wrong Budget Forecast


The non-functional currency portion of a balance sheet is particularly challenging to forecast. People around the world attempt to forecast various entities' balance sheets line-item-by-line-item in a decentralized manner, making this more difficult than it should be for many companies. As a result, there is often a lack of accountability or ownership of the company's balance sheet.

 

Income statement inputs, which tend to have more ownership and accountability, are a better source of information for determining balance sheet exposure because they tend to be more reliable. For this to be effective, it should be done in a centralized manner and based on accurate forecasts, rather than "stretch goals" or consistently, overly optimistic viewpoints. A "haircut" or "markup" may be necessary if a forecast input does not have a fairly equal chance of being either too high or too low over time.

 

Liquidity Management is a source of unnecessary volatility.


An FX risk management strategy is needed because of the volatility in currency markets. As a result, any additional volatility is extremely harmful.

When managing a company's liquidity needs, forecasting and optimally hedging the balance sheet can help avoid unnecessary volatility from spot or forward trading. Euro Accounts Receivable turning into Euro cash does not affect the USD functional sales entity's local currency balance sheet, as these are both Net Monetary Assets (NMA).

 

The ideal balance sheet hedging process would result in an equal and offsetting adjustment to the outstanding balance sheet hedges if a company wanted to convert any excess EUR funds to USD (which will affect the EUR NMA). Even FX swaps, rather than just spot trades or outright forwards, are employed herein. Even swaps can be used to manage liquidity needs regardless of the company's "netting day" or any other time of the month. This avoids unnecessary spot rate versus accounting rate impact and eliminates the need to guess on collections or payables timing.

 

Too much reliance on spreadsheets


When it comes to FX risk management, using only spreadsheets is a bad idea unless your business structure and FX exposures are extremely simple. Using multiple dimensions, such as currency and time, entity, and exposure line items can quickly exceed the two-dimensional capabilities of spreadsheets. Multiple spreadsheet tabs or other spreadsheets can be extremely vulnerable and error-prone if they are linked together (copying the wrong line of data, flipping the sign of exposure, version control issues, etc).

 

There are too many spreadsheets out there that are only accessible to their creator, which may be good for their job security, but not so good as an ongoing risk management solution. Investing in a platform that can handle all of the complexities of FX exposure management is highly recommended.

 

Excessive Transaction Fees


In many cases, banks are being compensated far more than is necessary for the risk they are taking in FX transactions. The person on the other side of the transaction must understand the market dynamics because they will be trying to maximize their profit. At the very least, a corporate FX trader should be aware of the market's current state at all times. Without real-time data, don't assume you're getting a good deal.


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