Currency Risk Management for International Trade. 8 Methods for Hedging Currency Risks

October 18, 2010 by · Leave a Comment
Filed under: Forex 

Currency Risk Management

Currency exposure
As can be seen from most charts and surveys, currency movements have been relatively volatile during recent years, making currency exposure an even more important aspect in connection with international trade, as well as foreign investments, particularly if the currency risk is outstanding for longer periods. Even for those currencies that have developed rather well (seen over a longer time-span) this is not in itself a protection when it comes to new transactions, primarily for two reasons.

First, a historical perspective can never be taken as proof for future currency development, particularly when past development has been strong and a correction might be more likely. Second, it is quite usual that these long-term trends are quite opposite to the short-term development, and it is this short-term trend that is more important when evaluating the risk aspects of a new transaction. It is the actual exchange rate that is relevant, whether this is established through a spot or forward transaction.
In order to evaluate currency risks, every company must know what types of risk may occur and to decide what risks should be covered in that particular case. The currency exposure for a company, or the ‘translation exposure’ as it is also called, is often divided into two separate parts: balance exposure and payment exposure.
Balance exposure is, in principle, an accounting risk, which may appear in the company’s books when consolidating foreign assets. When assets and liabilities are converted into the consolidated accounts of the group for accounting purposes, these figures will be calculated at different exchange rates, and might then give a distorted picture of the real value of the assets.
For example, assets abroad, which are financed through a foreign currency loan, are normally included in the consolidated statements at the acquisition rate, whereas the corresponding loan is valued at the higher of the acquisition rate and the rate when closing the accounts. Therefore, moving exchange rates will always have an effect on the accounts of the business, either positively or negatively. However, these exchange adjustments may be inaccurate if they do not reflect the true value of the assets and are not accompanied by any cash flow consequences.

Payment exposure, on the other hand, involves the flow of payments in foreign currencies, within both the parent company and its subsidiaries, in connection with sales and purchases of goods and services, interest payments and dividends, etc. This currency exposure is real and realized when the transactions occur, and the effective exchange rates instantly affect the cash flow of the company and the operating result of the group. In the following text, we will deal with payment exposure only, since this is related to trade transactions.
Most companies have different attitudes to currency exposure, dependent on factors such as currency volumes, its composition over time and what currencies are involved. Even the attitude towards risk within the company is important, as laid down in its general financial strategy.

Often you will find one of the following three main alternatives when dealing with currency risks:
 To try to keep the currency exposure as low as possible at all times and to cover the risks systematically as they occur, in order to minimize the overall currency risk.
 To aim at a selective coverage to keep the currency exposure within specified limits set by the company. The most common ways of achieving this are covering only certain currencies, only amounts above certain limits, only exposure over certain periods of time or to use some form of proportionate coverage. A combination of these alternatives is most often chosen.
 Not to cover the exposure at all, an alternative which may be chosen when the volumes and the outstanding exposure are small in comparison with the total business of the company, perhaps in combination with past experience about the strength of their own currency.
Most companies use one of the first two alternatives, actively trying to limit or minimize the currency risks involved in their business.

Hedging currency risks
The most common methods of hedging currency exposure are shown below; in practice, a combination of these alternatives is most often used:
 choice of invoicing currency;
 currency steering;
 payments brought forward;
 forward currency contracts;
 currency options;
 short-term currency loans;
 currency clauses;
 tender exchange rate insurance.

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