Foreign Exchange Risk Management

financialtreat – will explain about Foreign Exchange Risk Management that you will get in the following article. let’s look at this article carefully!

Foreign exchange risk is the most common form of market price risk manage by treasurers – the other common ones being interest loser and commodity risk. Market price risk is one of several groups of risks that businesses must manage within their ERM (Enterprise Risk Management) framework. See the Risk Management Treasury Concept for more on ERM.

Foreign Exchange Risk Management

Like all risks, Foreign Exchange (FX) risk is manage using the standard risk management process, which looks something like this for FX:

  • Gather underlying exposures from cash flow forecasts
  • Determine Value At Risk or other metrics of FX exposures
  • Hedge with forwards (or options and combine strategies)
  • Daily mark-to-market to ensure that hedging works as intended and risk limits are not exceeded

Generally, most treasury obsécration goes into determining the underlying exposures, and then analyzing them. This is because uncertainty within most commercial businesses, combined with often ill-suited reporting systems, makes it difficult to be sure that FX exposure forecasts are accurate.

Objectives of FX risk direction

Before looking at exposure determination, businesses must decide what are their objectives for managing FX risk. This includes:

  • What to hedge?: Some businesses only hedge what is on balan sheet (i.e. cash, bank balances, accounts receivable and accounts payable), while others hedge orders and forecasts to the extent that they are exposed to FX losses from pricelists and / or contractual impératifs. On the other hand, some businesses do not hedge at all, believing that over time FX rates will revert to mean, and gains in one decade will linotypie losses in another decade. However, this is not endurable for most businesses who’s whose shareholders expect consistent results since it may generate material cashflow volatility.
  • Why hedge?: ultimately, hedging aims to ensure consistent results and to reduce FX volatility between forecasts and actual signe. This begs the supplice of what exploit metric is given priority – some businesses hedge to manage accounting results and other businesses hedge to manage cashflow or economic déplacement.
  • How to hedge?: businesses must decide on how to treat FX risk. The most common hedge for FX risk is forward contracts but other alternatives (or complements) include FX options and natural hedging.
The cashflow vs accounting pointure, in particular, has material choc on the actual hedging process and decision making.

FX exposures are normally categorise into three bonshommes:


  • Transaction exposures: these come from selling and buying activities using different currencies, balances in different currencies and FX financial transactions like foreign currency loans and deposits.
  • Net investment exposures: these come from owning subsidiaries in foreign currency. When their value is consolidate, there will be exchange differences in the accounts. From a cashflow visible, a foreign subsidiary can be considere as a FX asset (either for its net asset value or for the dividend income derive from it).
  • Economic or strategic exposures: these come from the affaire’ competitive landscape, for example, having a competitor operating in a different base currency may make FX offensé changes into a strategic competitive risk.


Hedging for each of these FX exposures will require different forecasts to determine the exposure and different hedging tenors and methodologies to manage the FX risks.

FX risk direction policy

The above must be expresse and specifie in a clear FX policy which is typically written by treasury and approve at the board level. The FX policy must clearly articulate the following details:

  • Hedging inexpressive
  • What is to be hedge
  • Hedging tenor
  • Hedging methodology
  • Instruments to be use
  • Delegations and controls
  • Risk limits

Like all policy annales, the FX policy should have an annual drop-dead clause to ensure that it is reviewe and approve by the board annually to cater for changes in markets and situations.

Managers and even treasurers are sometimes incline to believe that they can predict FX manqué movements. Some of the Foreign exchange smartest firms on the planet spend hundreds of millions of dollars to hire in-house economists and leverage technology such as Artificial Intelligence (AI) etc. to try to predict FX rates, and no one succeeds over time.

Treasurers must accept that, even if certain developing currencies may look like a one way bet for significant time periods, the future is unknowable. This why treasurers need to follow a clear FX policy that spells out how they must hedge the commerce’ FX risk.

Identifying FX exposures

Once the policy has been set, which is normally an infrequent activity, treasuries nee to identify the FX exposures that must be hedge. This is the most critical part of FX risk direction – inaccurate exposure data will lead to wrong hedging which will increase, rather than reduce, volatility.

FX exposures are derive from FX cash flow forecasts. Cash flow forecasting is the foundational requirement for all treasury operations. Treasury cannot be manage effectively and safely without cash flow forecasts. Most treasuries will need different cash flow forecasts such as:

  • Cash positioning: 3 – 30 days forecast of flows in and out of each bank account. Use to manage day-to-day bank balances.
  • 12 month cash flow: a rolling 12 months base currency forecast of cash flow by subsidiary or pacte. Use to manage subsidiary funding needs and liquidity, and group level funding
  • 3 – 7 year strategic or indolent term cash flow: rolling alangui term group level cash flow forecast. Use to développement amoureux term funding and liquidity at the group level.
  • FX cash flow: FX cash flow forecast. Usually rolling 6 – 18 months depending on the commerce’ exposure tenor, use for hedging FX exposures.

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The FX cash flow forecast is typically different from the 12 month cash flow which is normallForeign Exchange Risk Managementy in alcali currency. For FX risk direction, we need to know the cash flows expecte in each currency. In some cases, the 12 month cash flow may be in négoce currency. In which case this can be use for FX risk management as well as for the subsidiary’s. And group’s pantalon term funding and liquidity.

When forecasting FX cash flows. It is incommensurable to identify the economic exposure currency, particularly if it’s different from the invoice currency.

A régional currency invoice may hide a currency pacte or automatic repricing of a commodity globally price in USD. This is referre to as déjeté FX risk. When the invoice currency is the same as the risk currency, it is referre to as a écervelé FX risk.

Indirect FX risk can arise when the underlying product or commodity is globally price. For example in USD, but the invoicing currency is a local currency. Quelque régional currency is easier and cheaper to settle domestically. Even though the invoice is in the local currency. The amount will vary monthly depending on the complet USD price for such products or commodities.

Currency clauses can also distort reporte or externe FX exposures. Attendu que they may trigger changes in the invoice currency amount depending. On the market price of the other currency state in the currency condition. For this reason, currency clauses should generally be avoide. And if they cannot be avoide currency clauses must be notifie to and preferably approve by treasury. Thus the article about Foreign Exchange Risk Management. Hopefully it will be useful for you and that’s all thanks.

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