Corporate treasuries are generally not aggressive profit centres these days and are typically conservative when it comes to foreign exchange risk management. They also often have to follow well-defined guidelines on how to manage their firm’s foreign exchange risk.
To prevent mismanagement of foreign exchange risk, corporations should ideally have a policy that details exactly what needs to be done when the company faces the various types of foreign exchange risks that can occur in its business operations.
Often, such a policy will be developed along with a process for measuring exposure. For corporations that have a relatively low risk exposure, measuring it can be a very straightforward process of estimating the likely cash receipts or payments for a given time period.
Nevertheless, for UK companies that buy or sell products in Pounds Sterling that are traditionally priced in U.S. Dollars in the global marketplace, the currency risks are less obvious, but just as material to the firm’s bottom line.
A sound foreign currency management policy is crucial to the operation of the treasury department of any company that does business overseas. Without such a policy in place, currency hedging decisions are often made randomly, without any accountability or consistency.
Treasury personnel need appropriate guidelines to aim for when hedging currency risk. Also, senior management and the board need to feel confident that the foreign exchange risks of the business are being managed in a prudent way that is consistent with the overall corporate strategy.
Recognising that substantial foreign exchange risks exist for a company means that some important strategic decisions will need to be made about how to manage those risks. When doing so, a good manager will take a rational and strategic approach to their decision making process.
A common management method involves devising suitable responses to foreign exchange market movements in order to reduce emotional responses and rely instead on careful planning. This method helps reduce panic by considering all possible outcomes, including the 'worst case scenarios' that might occur either due to inaction or due to action that ultimately turned out to be unfavourable.
When the worst case scenarios are taken into account, the strategic planning process helps ensure that even that admittedly undesirable result is acceptable. With that noted, the planning process focuses on taking appropriate action to achieve the best result.
Currency risk management is a key management issue, as evidenced by the widespread use of forex risk management tools and the exceptional amount of literature published on the subject. Considerable academic attention has also been focused towards enhancing corporate risk management methods.
Active forex risk management is also a common practice in the vast majority of major corporations the world over that have substantial foreign currency exposures. To not manage this key financial risk is considered negligent, since a firm's management shares the responsibility for overseeing all variables that eventually affect the company’s profitability.
Once it has been determined that a company has foreign exchange exposures, it becomes prudent to develop a strategy to deal with them. Without such strategies, hedging decisions that involve buying or selling currencies become much more difficult to make.
Furthermore, not having a coherent risk management strategy often results in an exposure being mismanaged since people are typically only jolted into action when they perceive a problem.
Several alternative foreign exchange strategies can be used to manage currency risk:
1) Do nothing to hedge and only execute currency transactions when necessary.
2) Hedge future currency obligations when recognised. Smaller corporations typically use this strategy.
3) Optimise the levels at which currency transactions are made. Corporations using this strategy aim to get the best exchange rate during the time frame from when a forex exposure has been recognised until when the currency exchange become necessary. They might do this using a strategy that sets target exchange rate levels for their transactions.
Strategies 1) and 2) above are often used because of their simplicity. They require no additional decision making, are easy to manage, and have been used for so long that some corporations are not even aware of alternatives. Nevertheless, these strategies are flawed because they involve taking substantial risk with the company’s cash flows and represent extreme positions.
Hedging every exposure removes the chance that the market may move favourably, while competitors could benefit from such exchange rate shifts. This places the cash flows at risk since competitors may cut their prices and so profit margins are reduced due to lower revenues caused by hedging.
Failing to cover currency exposures leaves the corporation vulnerable to unfavourable market movements that could result in substantial cost increases. This can be just as harmful to a company’s margins as revenue declines and it even has the potential to undermine the firm’s overall profitability.
Those who believe in managing currency variables that can impact a business’ profitability typically use the foreign exchange management approach. This involves making decisions about and taking control of the currency exposures that affect a corporation’s bottom line. This process can take various forms ranging from very rigid and conservative strategies based on their ease of administration, to more complicated strategies that try to maximise results by taking certain risks.
UKForex encourages strategic contingency planning where decisions are made in advance of the need to execute transactions. Treasury personnel should also agree to use the risk management approach consistently, and it should be approved by the CFO and Board of Directors.