Why a corporate FX policy is a must to manage foreign exchange volatility
A growing number of businesses have at least some, if not significant, association with overseas markets and, by extension, exposure to foreign exchange risk.
They may have customers internationally who seek to buy their products using local currency, suppliers located overseas invoicing in their own currency, satellite offices situated in foreign markets requiring local currency transactions or, in many cases, all of the above.
“Doing business overseas has inherent financial risks as you’ll be dealing with, in one fashion or another, currency translation between your home currency and currencies of the countries in which you operate,” says William R. Schumaker, vice president and foreign exchange advisor in International Banking at Bridge Bank.
It’s early, but 2015 has seen staggering currency volatility as international events, Central Bank pronouncements, disparate interest rate outlooks and monetary policy revisions have all contributed to currency fluctuations not seen in decades.
Currency volatility can have a severely adverse effect on a company’s bottom line, but it doesn’t need to.
Smart Business spoke with Schumaker about the keys to developing and executing an effective FX risk management policy.
What is an FX policy and why is it important?
An FX policy is a documented set of directives outlining organizational objectives, strategies and procedures with regard to managing currency risk. It should include exposure types to be managed, and tactics to be implemented to alleviate this risk, including specific financial instruments to be utilized.
You need a formalized approach to your risk management activities in order to avoid any sense of ambiguity or uncertainty when faced with FX decisions and to have a consistent blueprint from which to manage risk.
Changes in FX rates directly influence the overall costs and profitability for an organization relative to overseas business dealings. Failure to implement an FX risk management plan can leave your company exposed and ill-prepared to manage the effects of unfavorable currency moves.
What factors need to be considered prior to developing an FX policy?
Risk identification is paramount in importance, so it’s imperative to pinpoint which company transactions (present and future) pose potential FX risk. This could be payrolls, receivables, payables, foreign profits and taxes, or any number of operating expenses fundamental to international business.
After you’ve identified where your exposures lie, you must quantify them.
You cannot manage what you have not measured. Develop a forward-looking snapshot of fixed, and to the extent you are able, variable foreign items. Once appraised, the effects of potential unfavorable currency swings can be quantified, scenario analyses performed and a calculated perception of what negative effects of currency volatility can mean to your business going forward.
An FX policy needs a formal statement of objectives. Specific objectives for managing foreign exchange risks are certainly subjective and will vary from business to business.
The policy should, however, outline what the policy seeks to accomplish. Is the priority to minimize the costs of international payables/receivables? Is it to optimize profits from overseas business?
Other considerations may be to specify the time frame to apply to your plan (How far out should exposures be hedged?) and to establish precise hedging ratios.
Also, companies should determine what level of risk they are willing to accept as well as an outline of how risks are to be measured and what internal controls are to be instigated.
How much capital — financial, human and technology — is the firm willing to expend to execute its FX hedging program? The policy should also establish individual responsibilities for those directly involved in the hedging process and lines of reporting.
While general operating procedures within an organization can often be dynamic, having a clear-cut practice for managing currency risk will be beneficial as the organizational structure offered will provide clear guidelines that will bode well for the business over time.
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