Challenges in FX risk management

Reflecting on the impact of COVID-19 on hedging

What you’ll learn

  • Understand the types of FX risks.
  • Understand the challenges in managing FX risks.
  • Learn the ways to manage FX risks effectively.

The rise in FX volatility due to COVID-19

The pandemic had a significant impact on foreign exchange (FX) markets, causing organizations' current market values to deplete. As a result of the high FX volatility, the valuation of FX derivatives as well as foreign currency assets and liabilities fluctuates significantly from day to day. Multinational enterprises dealing with multiple currencies find it difficult to forecast the impact of these risk factors on operating performance. This leads to significant forecast error in company projections, reducing the effectiveness of foreign exchange hedging.

Types of FX risks

Primarily, FX risks arise from the need of converting cash from one currency into another as a result of a transaction or internal transfer.

There are three types of FX risks that enterprises are exposed to:

  • Economic risks

    It is a type of foreign exchange risk caused by unexpected currency fluctuations.

  • Transaction risk

    When a parent company owns a subsidiary in another country, the subsidiary’s financial statements, which will be denominated in that country’s currency, must be translated back to the parent company’s currency.

  • Translation Risk

    This risk is associated with a company purchasing a product from a company in another country.

Challenges in managing FX risks

Managing FX risks is challenging as it is difficult to forecast the impact of these risk factors on working capital management. The extreme level of volatility experienced in FX markets over the past couple of years has highlighted the need for businesses to carefully consider their FX hedging requirements. The challenges in managing FX risks can be broadly classified into these two categories :

  • Lack of structured hedging strategy:

    Many businesses’ hesitation to implement a formal, recorded hedging policy is reasonable, as the need to stay flexible when managing risk in turbulent FX markets is critical, and formal hedging policies may be difficult and rigid.

  • Absence of appropriate performance tracking:

    Performance measurement is necessary for any business activity to determine the effectiveness of hedging. The inability to track the exposures in FX risks and the way the business is handling the FX risks can affect the organization’s foreign exchange(FX) risk management.

Overcoming foreign exchange risks through hedging

The inherent challenges of FX trading are well known to treasurers in enterprises. FX risks can be minimized by employing efficient hedge tactics before trading. It is important to emphasize that hedging practices are not meant to generate profit but rather to protect the company and avoid substantial losses.

Ways to improve managing FX risks

  • Mitigate risk in the pre-trading stage: Hedging activities safeguard future exposure to foreign exchange from adverse changes in rates and prices. This method eliminates all uncertainty inside an exchange rate, regardless of market fluctuations.
  • Perform commodities hedging: The company’s exposure may not be restricted to FX; depending on its business line, other asset classes may also be hedged. Commodities hedging are necessary because their prices are likewise vulnerable to multiple changes. This decreases exposure to potential losses, improves cost-effectiveness, boosts profitability to identify new business prospects.

Best practices for cash flow hedging

Uncertainties in revenue and cost projections, as well as the complexity of the foreign exchange market and related derivatives, all may contribute to concerns about the efficacy of the hedging activities.

A company’s valuation depends on the amount and consistency of its future cash flows, so lowering FX volatility through effective hedging improves its valuation and capital availability.

Ways to improve hedging

  • Develop a reliable forecast

    Companies can’t hedge a risk until they can monitor the risks, so developing an accurate forecast is crucial to track and mitigate the foreign exchange(FX) risks. The forecast process varies from company to company because the appropriate hedging strategy depends on how and where the company is incurring FX risk. Moreover, the forecasting process should integrate revenue and expense predictions from all of the company’s businesses whose net revenues are subject to foreign exchange risk.

  • Integrating cash flow and balance sheet programs

    Combining currency and cash flow hedging programs can reduce treasury effort and trading costs. Companies can look for trends in past periods’ balance sheet actuals, then anticipate future FX risks assuming those trends will continue or assuming that the current balance sheet snapshot is an appropriate proxy for exposure.

Methods for tracking FX fluctuations

A currency exchange rate forecast can assist brokers and businesses in making informed decisions in order to reduce risks and increase profits. Many methods of forecasting currency exchange rates exist. Here look at a few of the most popular processes :

  • Identify consolidated foreign currency exposures using a bottom-up method

    Determine the currencies in which each subsidiary collects receivables and pays out. Identify assets and liabilities denominated in a currency other than the functional currency of the specific subsidiary, such as intercompany receivables and payables.

  • Determine each subsidiary’s expected yearly foreign currency cash flows

    Estimate each subsidiary’s total receipts and payments in each currency each month for the following 12 months. To calculate the company’s overall annual net anticipated foreign currency cash flows, add the total planned receipts and payables by foreign currency (other than the corresponding subsidiary’s functional currency) for each subsidiary by month.

  • Prepare foreign currency assets and liabilities

    Some of the foreign currency balance sheet exposure should be naturally offset or netted as a result of the consolidation. The remaining net consolidated balance sheet positions by foreign currency should reflect the exposure that will be remeasured as a result of changes in foreign exchange rates, with the resulting impacts being reflected in the income statement.

Schedule a demo to learn how HighRadius cash flow forecasting software can help you identify and mitigate FX risks proactively.

There's no time like the present

Get a Demo of Integrated Receivables Platform for Your Business

Request a Demo
Request Demo Character Man

HighRadius Integrated Receivables Software Platform is the world's only end-to-end accounts receivable software platform to lower DSO and bad-debt, automate cash posting, speed-up collections, and dispute resolution, and improve team productivity. It leverages RivanaTM Artificial Intelligence for Accounts Receivable to convert receivables faster and more effectively by using machine learning for accurate decision making across both credit and receivable processes and also enables suppliers to digitally connect with buyers via the radiusOneTM network, closing the loop from the supplier accounts receivable process to the buyer accounts payable process. Integrated Receivables have been divided into 6 distinct applications: Credit Software, EIPP Software, Cash Application Software, Deductions Software, Collections Software, and ERP Payment Gateway - covering the entire gamut of credit-to-cash.

NL Banner Sticky

Get the hottest Accounts Receivable stories

delivered straight to your inbox!