How to Create a Solid Foreign Exchange Risk Management Strategy

Any business trading internationally assumes a certain amount of risk, due to fluctuating foreign exchange (forex) rates. It’s estimated that an average of $5 trillion in currency is traded every single day in an attempt to take advantage of rate changes, but even simple transactions unrelated to this can impact a company’s bottom line if things move in an unfavourable direction.

For example, if a US company pays a European company €1 million when the exchange rate is $1.00:€1.00, the outgoing amount is $1 million. However, if the exchange rate were to fluctuate to $1.10:€1.00, the same debt would cost the US firm $1.1 million; an additional cost of $100,000.

This possibility is why companies that frequently trade internationally adopt risk management strategies. These sets of tactics enable businesses to mitigate some of the dangers of forex rate fluctuation, and in some cases even profit from them. Every organization’s risk management strategy will be different, but these are some of the most frequent steps taken.

Forward exchange contracts

Perhaps the most simple option to mitigate forex risk is to make use of forward exchange contracts; binding agreements that lock in an exchange rate for a particular transaction on a future date. If an exchange rate looks good, a business can therefore secure it for future payments and guard against it becoming less favourable.

Of course, this also locks it in even if the exchange rate becomes much better, leaving companies potentially missing out on greater savings, depending on which way the forex market moves. Nevertheless, this is still preferable for a great many organizations due to the fact that it allows them to budget more accurately and not have to worry about exchange rate fluctuations altering their outgoings.

This type of risk hedging works best when combined with large purchases such as property, especially when the exchange of money is happening a long time in the future. It also requires a small amount of knowledge about historical exchange rates, so businesses can identify the right time to secure a forward exchange contract.

Put options

While forward contracts will be the best option in most cases, companies can also turn to put options to hedge forex risk. This type of option essentially functions as a contract to sell a currency pair at a given exchange rate by a specific future date. If a company enters into a transaction and doesn’t have time to benefit from a forward exchange contract, it can fall back on its put options to purchase the currency it needs at a beneficial exchange rate.

Because this type of risk management isn’t tied to a particular transaction it can potentially be more flexible than forward exchange contracts. However, the downside is that setting up a put option will cost a premium. If the option isn’t utilised before it expires, that premium will have been spent for nothing.

Exotic options

An exotic option is similar, but is more involved. In this scenario, a company bets on the movement of exchange rates in a similar manner to general forex trading, essentially predicting what the value of one currency will be compared to another at a specified point in time. This option also costs a premium, but will pay out if successful.

To benefit from this as a risk management strategy, a company would need to match it to a future transaction. For example, if a US business is making a purchase in euros in a month's time, it might opt for an exotic option predicting the rate will fall below a certain level. That way if the rate remains favourable, the company saves money, but if it drops then the option should ideally offset the loss.

Choosing between forward contracts and options depends on a range of factors. Paul Houston, Executive Director and Global Head of FX at CME Group, points out that lower exchange rate volatility tends to make options more preferable.