Currency fluctuations pose a financial risk to the P&L and balance sheet for companies buying, selling, or operating in more than one currency. Managing currency volatility is important for financial stewards at all levels of a company, from the CEO and the boardroom to the CFO, treasurer, and foreign exchange (FX) manager.
To minimize exposure, you can approach currency risk management in three broad steps:
- Assess risk exposure. Understand your currency risk exposure through quantitative analysis. A Value at Risk (VaR) analysis considers all the types of FX risk exposures across your company’s global footprint. This can include revenues, expenses, asset values, and intercompany transactions. The layering in of currencies and geographies increases the complexity of the analysis.It’s important to assess how different exposures interact within a risk portfolio. A composite risk profile emerges based on understanding how various hedging strategies or the absence of hedging could affect financial results based on currency rate fluctuations.
- Establish a hedging policy. Determine whether to engage in hedging based on your understanding of risk-reward and costs. If your company finds value in a hedging program, then next steps are to establish a hedging policy. The policy will outline financial goals, types of exposure to hedge, how to hedge, and accounting implications of hedging.
- Hedge currency volatility. As a best practice, a natural hedge is an efficient risk-mitigation tool. Realistically, though, most companies cannot eliminate their total exposures through natural hedging. At a minimum, there tends to be some residual risk in profit and/or asset holdings.Companies often look to short-term hedging tools to protect profitability and long-term capital structure hedges to minimize volatility related to overseas holdings.
- “Balance sheet.” A key risk is the depreciation of receivables denominated in foreign currency between the time of booking the receivable and collecting payment from customers for conversion. The mirror exposure results from the appreciation of foreign currency payables. Approximately three out of four companies will hedge their short-term currency exposures related to receivables.1
- Cash flow. Companies with longstanding business in a market may hedge anticipated sales over the course of a year. Roughly two in three companies hedge this type of exposure. Hedges usually extend anywhere from six to 12 months. A standard approach is to hedge to protect the company’s budget forecast or margins. Companies with strong pricing/buying power may be able to influence pricing and pass on currency fluctuations, and therefore rely less on hedging.
- Capital structure. Companies with business units or subsidiaries operating in foreign countries may seek to mitigate the effect of currency fluctuations on the valuation of these foreign assets. Long-term hedges often consider multicurrency debt as a component of capital structure. This can involve, among other things, swapping some U.S. dollar debt into local currency or issuing local-currency debt.
The bottom line on hedging
Minimizing the impact of currency volatility is a vital aspect of financial risk management. Understanding the risk, establishing the proper policy and accounting treatments, and applying the right hedges for your business are keys to a successful currency risk management program.
1. “Foreign Exchange (FX): 2016 Risk Management Practices Survey,” Wells Fargo.
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