Currency risk is one of the three types of foreign exchange exposure (FX). Companies typically have a FX hedging strategy in place to mitigate currency risk. However, before we even consider hedging, the first priority is to identify and, depending on the type of risk, accurately measure or estimate it.
There are many time-tested solutions for managing FX risk, yet too many companies come a cropper over pitfalls that are easily avoidable (blind spots in their risk mapping, poorly synchronised financial tools, input errors and more).
This article will explain how to improve management of transaction risk by applying 3 tried-and-true key principles.
The two faces of FX transaction risk
If FX transaction risk was a god, it would obviously be Janus, the Roman god with two faces. Why? Simply because it also has two “faces”.
It has to do with timing: the first face (balance sheet exposure) looks to past transactions. It concerns items on your company’s balance sheet denominated in foreign currency, such as trade receivables, trade payables and investments.
The second face (cash flow exposure) is turned to the future and is focused on your upcoming FX transactions, including purchase or sale invoices, commercial proposals sent to customers, price lists, etc.
In both these cases, FX transaction exposure is the risk of a future change in the value of the contract. Whether or not your company attempts to hedge against such an eventuality, it is critical to be aware of the risk.
And here’s the problem: companies that do not implement the three best practices below will not have accurate information on their currency risk.
Three keys to successfully manage your FX transaction risk
Robust FX management methods are necessary but not sufficient in themselves to tame your company’s FX risk. You also have to ensure your methodology is correctly applied to accurately measure your balance sheet exposure and precisely estimate your cash flow forecast exposure.
1. Prepare exhaustive exposures mapping
Blind spots are the real danger on the road or in the corporate world. Don’t ever be caught off guard: draw up a comprehensive map of all the factors likely to create a transaction risk for your company.
2. Synchronise your tools (in real time)
Unsynchronised tools (sales planning, ERPs, financial software) heighten the risk of software bugs and human error. By synchronising your working tools – if possible in real time – you’ll not only eliminate this operational risk but also cut out very time-consuming tasks: double input, manual checks, importing/exporting data, and more.
3. Make your reporting intelligible
Complete and up-to-date information is a good start, but you also need to understand and correctly interpret your data to make the right management decisions quickly. Don’t overlook the importance of drafting clear reports and apply best data visualisation practices.
Once you’ve started using the three key principles outlined in this article and have a good grasp of your FX transaction risk, all you need to do is to monitor your market risk upstream and your FX transaction risk downstream to control all aspects of your company’s foreign exchange risk, from A to Z.