Business leaders need to understand their exposure to foreign exchange (FX) volatility and the risk it presents to their companies, says Gareth Sylvester, senior vice president and foreign exchange advisor at Bridge Bank.

“First and foremost, it’s about understanding what your actual exposure is; quantifying it and then understanding your own risk tolerances and desired outcome for managing the risk,” Sylvester says.

“Moreover, it’s essential that FX risks be proactively versus reactively managed. While there is never a ‘perfect hedge,’ even establishing the simplest policy to mitigate a portion of your exposure is better than no hedge at all.”

You need to be able to position your business to tackle FX risk from a position of strength rather than making decisions due to fear, lack of preparation and urgency, Sylvester says.

Smart Business spoke with Sylvester about FX volatility and what you need to know to safeguard your business.

What are the greatest concerns for businesses when it comes to FX exposure?

In the case of most treasurers, it is the financial impact on the businesses from excessive FX market volatility or a rapid appreciation/depreciation of a currency that creates the greatest of concerns. Regardless of whether you are importing or exporting, the fears remain the same.

What is the impact on my payables/receivables from FX volatility and how does this affect my competitiveness from a product pricing perspective within the region I operate?

While most treasurers will factor into their budget a degree of FX volatility, a significant adverse FX swing can result in, at best, a small decrease in the value of your expected receipts. At worst, it can result in your product or service no longer being price competitive in a certain geographical region.

Where should a business leader begin in trying to proactively address these risks?

The first thing is to identify in what form the FX exposure risk arrives. Is it transactional, translational or economic in nature? In most instances, businesses are faced with transactional risk wherein the value of their payables/receivables is affected by FX market moves. Another key question you want to be sure to answer is when does the business recognize a transactional FX exposure?

Does it happen at the time an invoice is received or submitted, when cash is paid or received, or on historical business trends and volumes? Once the exposure is identified, the second stage is to measure and quantify this risk and the potential impact to the business. Depending on the size of the international exposure, some organizations will also assess the impact on their margins in order to assess risk.

The next step is to determine your goals for managing the FX risk. Are you looking to minimize earnings volatility, for example? You also want to gauge what level of risk exposure the company is prepared to take.

This will help calculate the correct volumes to be hedged, over what time horizon and perhaps even the hedging instruments. Lastly, and crucially, it is imperative to measure the effectiveness of the hedge program.

Did you achieve your goals? Did it minimize the effects of FX volatility? If so, that’s great news, but you’ll still want to review again in three to six months. If not, you need to adjust your hedge approach and review it again in three months.

How difficult is FX management in terms of the need to go back and make adjustments as conditions in the market change?

Any FX hedging program should have clear and defined objectives. The FX policy is intended to be a living, breathing document. A hedging framework and policy document should never be drafted, signed off, filed and ignored. It is paramount that periodic effectiveness reviews are conducted to ensure that the key objectives for managing the FX risk in the first place are being met.

Failure should prompt a process review in order to determine where the inefficiencies are arising and what can be done to rectify these concerns.