Global multinationals are exposed to foreign exchange (FX) risk on a daily basis and even with

adequate people and technology resources may struggle to manage it proactively. Small domestic

companies can see their competitive advantage eroded if foreign competitors benefit from a

favourable rates.

 

FX movements affect us all, and have done for centuries, but have received greater focus in recent

years due to globalisation, innovation and automation in financial markets and government

intervention.

 

This leaves business exposed to multiple risks:

 

1. Translation Risk

Occurs when a subsidiary’s financial statements are converted from its local operating currency to the parent’s base reporting currency. May impact the P&L, B. Sheet and Cash Flow statements of the parent, in turn affecting covenants. Companies may not hedge this due to its long-term nature and because hedging may create reporting distortions which affect comparability.

 

2. Transaction Risk

Occurs on conversion of one currency to another, such as for sales, purchases, funding or dividends. The exposure is subject to mark-to-market accounting with the resulting gain or loss reflected in the P&L.

 

3. Economic Risk

When FX movements make a company uncompetitive versus an international peer, even if it operates only in its domestic market. As an embedded business risk it is hard to hedge

 

4. Future Risk

An exposure which will arise in the future, either already contracted, planned or unexpected.

Intro to FX risk Managing FX risk

Impact on Shareholder Value

Unhedged FX movements can impact the Profit & Loss, B. Sheet and Cash

flows.

 

In this simple example a UK company has to fund their subsidiary in

Germany at EUR 1m per month for the next year (A).

 

Based on current GBP:EUR forward rates they have an unfavourable outlook, having to 'pay' GBP 838k in Dec 2013 rising to GBP 855k by Dec 2014 to cover the same EUR 1m (B).

 

For internal planning purposes they have budgetted 1.190 as the average

GBP:EUR rate for the next year. Based on current forward rates that will result in a loss of GBP 56k over the period (C).

If Rates Rise

Due to unforeseen macro events GBP Sterling moves in their favour,

appreciating 10% against the Euro.

 

Assuming this shift is applied across the period, the company now have to

'pay' only GBP 762k in Dec 2013 rising to GBP 778k in Dec 2014 to cover the

same EUR 1m (B).

 

For internal planning purposes their budgeted average rate of 1.190 for

GBP:EUR would result in a profit of GBP 942k over the period (C).

If Rates Fall

However, if GBP Sterling were to depreciate 10% against the Euro the

position becomes unfavorable:

 

Assuming this shift is applied across the period, the company now have to

'pay' GBP 932k in Dec 2013 rising to GBP 952k in Dec 2014 to cover the same

EUR 1m (B).

 

For internal planning purposes their budgeted average rate of 1.190 for

GBP:EUR would  result in a loss of GBP 1,276k over the period (C).

If Hedged

To hedge their risk the company trade an FX Forward, locking in their future Euro purchases at a rate of 1.1875 (A).  

 

This provides certainty on monthly cash flows (B).

 

It also provides a cash flow profit of GBP 33k over the period, as they are locked at 1.1875 thus protected against the downside movement in GBP:EUR (C).

 

locking in means they cannot benefit from any upside in GBP:EUR above 1.1875 (hence it shows a loss in the months when rates are above this).

 

For simplicity reasons we do not consider hedge accounting in this example.

 

 

 

 

 

To learn more about managing FX risk please read our simple guides