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Treasury Consulting > Corporate foreign exchange risk

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Published: 6th December 2009 by William Webster

Corporate foreign exchange risk

Unexpected gains and losses from foreign exchange risk can complicate running a company. At the moment you may be selling off currency on an ad-hoc basis and it's the first time you have considered managing the exposure what can you do? Here are 11 points that may help.

  1. Identify what is giving you the foreign exchange risk. Suppose your business is UK based and you export to Europe. Invoicing in EUR will give you a GBP/EUR exposure. (You get paid in EUR but your cost base and profit is in GBP).
  2. Quantify the size of the risk. What proportion of your sales (in financial terms) are in EUR? This is where a budget helps. If you have your sales projections over the next year you can see what percentage of your revenue is in foreign currency.
  3. Is this exposure material? That's a question you have to answer. Using your projections alter the rate you convert your foreign exchange into GBP and see the effect on your revenue.
  4. What would it cost your business if there was a substantial change in the FX rate? How would this affect you? If you decide the risk is too great what can you do? You could use forward contracts with your bank.
  5. With a forward contract you sell an agreed amount of one currency (EUR) for another (GBP) on an agreed future date at a rate agreed today. It is important to understand that you will be obliged to fulfil the deal. This means you can't walk away from it if the prevailing spot rate is better. Additionally if you don’t receive the EUR you will have to close out the forward contact for a windfall loss or gain.
  6. How much of your revenue do you hedge? Again that's an issue for you to decide. There is a spectrum. You can sell all, none, or a proportion of the anticipated revenue. How good are your projections and how important is it to you to have a known conversion rate? You also need to consider how far forward you want to hedge. There is no right answer. Some companies hedge for three months, some for a year and some for longer periods. Then there is the practical aspect of dealing with your bank. Here are a few issues you need to consider.
  7. Banks will make money from dealing with you. How? They buy low and sell high. This is trading. And you need to keep dealing spreads to a minimum. That means if the amounts are large have more than one relationship bank, compare prices and invest in a price vendor.
  8. Banks may also ask for dealing fees or commissions. If they do look elsewhere.
  9. Resist any "security deposit" the bank asks for. Consider whether the bank has the right to call for additional margins and the effect it will have on your liquidity. Ask if interest is paid on any margin. And read the small print on anything you sign.
  10. Beware of exotic (option) transactions particularly if you are new to the game. Complex deals are hard to understand and difficult to value. Sometimes they genuinely solve problems but frequently the bank makes more money. Caveat Emptor.
  11. A final point. When and if you agree a forward contract its value will alter. You might win or lose. If you're winning you expect the bank to meet its obligations. What would happen if it didn't? That's not a question we used to ask. But it's why you need to do due diligence and not put all your eggs in one basket!

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