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Understanding & Managing Currency Risk

Companies operating in today's economy face myriad challenges including substantial currency fluctuations that can impact financial results.

Importance of Hedging Currency Exposures 

The importance of hedging currency exposures was referenced in a recent article in CFO Magazine. The article noted that many different market participants either buy products from companies in the euro zone or sell to them. These participants are exposing themselves to the impact that political turmoil could have on the value of the euro relative to other currencies.

Hedging The Euro

Many market experts have recommended that firms doing business with the euro zone create long-term contracts when possible and seek the advice of professionals who specialize in currency risk management, the media outlet reports.

In a New York Times article published at the end of last year, the author indicated that the euro zone fiscal crisis was forcing many investors and other market participants to reconsider their exposure to foreign markets.

For many years, these entities did not deliberately manage their international risk exposures, according to the news source. As a result of the economic turmoil in Europe, currency risk management took on a new level of importance as many wondered if the euro would remain viable in the long run.

U.S. Dollar

The euro zone is only one example of a region that is suffering from economic turmoil and the potential for wild currency fluctuations. Now that the U.S. presidential election has been decided, many investors are turning their attention to the fiscal cliff that will be triggered if lawmakers are unable to resolve their disagreements surrounding the federal budget.

Failure to solve these disputes will result in more than $600 billion worth of tax hikes and spending cuts, which could have a substantial impact on the value of the U.S. dollar and other safe haven currencies.

Companies that do business in more than one country can help to make their budgeting process more accurate if they effectively hedge their currency exposures. One way they can do this aside from locking in contracts with their suppliers, vendors and clients is utilizing foreign exchange derivatives.

Due Diligence

Firms can benefit from being sure they know where they are most at risk of having their financial transactions hampered by substantial currency fluctuations.

John Brittain, managing director at Accordion Partners, which provides financial services to companies, recommends that firms "understand [their] risks first, spend [their] time focusing on where the true transactional cash-based exposures are, and utilize the foreign exchange (FX) markets, particularly the forward and options markets for hedging those risks," according to the news source. 

While executing these strategies may seem like a simple task, companies have many opportunities to fail, the media outlet reports. They can potentially lose their focus on effectively managing currency risk exposures, use an ineffective hedging methodology or dismiss currency risk as being unimportant.

Even firms that sell goods in a single market can benefit from hedging, according to the news source. Brittain notes that if a company only sells products in the United States, it could source goods from various nations.

"Often you try to negotiate the currency risk on to your counterparty, but if you have to incur the FX exposure, you generally should hedge it in order to lock in the cost of your imported product for domestic sale to your customers."

Companies that find themselves in similar situations should be sure to effectively manage their currency risk exposures, as doing so will help to make their budgeting process more effective and accurate. 

 

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