Use our guide to understand and explore the factors that can make it advantageous to embrace a risk management strategy for foreign exchange. We provide you with perspective on how to develop a strategy, using a proven program with an efficient process.
The foreign exchange market can be a highly complex task for small-to-medium enterprises to navigate when conducting business overseas. It can also be one of the most crucial tasks of the business. Developing an effective risk-management strategy can be as critical for those businesses as having a viable business model. Indeed, in many cases a forex risk management strategy can be an integral component of the business model itself.
Globalization has created unprecedented opportunities for companies – small, medium and large – to expand internationally. More companies are venturing into foreign markets, buying and selling goods in places long considered out of reach for all but the largest multinationals.
These international ventures often create opportunities for growth, but they can also expose companies to foreign exchange risk. In a world where currencies are volatile and their movements hard to predict, profits can be wiped out in the blink of an eye.
Through no fault of their own, many businesses don’t know where to start or how to develop and execute a strategy for managing foreign exchange risk. They have neither the market intelligence, the connections to major market players, nor the trading expertise required to participate in the market effectively, at least not without direction.
The purpose of this white paper is to explore the factors that make it beneficial to embrace a risk management strategy for foreign exchange, to offer some perspective on how to develop one, and explore Corpay’s approach to risk management in foreign exchange.
The Foreign Exchange Market
The foreign exchange market is the largest financial market in the world. With a daily turnover estimated at about US$5 trillion, it dwarfs other asset classes such as equities and fixed income.
It’s also become noticeably more volatile as the advent of globalization has increased the flow of money from one economy to another – and from one financial market to the next.
This flow increase is a key factor in why the trading range of the Canadian dollar in the last 18 years is essentially twice that of the 18 years before then.
Foreign exchange is also a relatively opaque market. Given its trans-national nature, it’s lightly regulated in comparison with other financial markets. Price disclosure is less thorough than for exchange-traded assets, and liquidity in many currencies can fluctuate significantly, exacerbating the already high levels of volatility in the market.
Valuing currencies presents some unique difficulties, as well. The factors that impact currencies are usually broader and more complex than those affecting other assets such as equities. The valuation of a currency hinges to a large extent on an assessment of the strength of the economy it represents and the resulting trajectory of yields.
But buying a currency also means selling another – a feature that also distinguishes currencies from other assets. The valuation required is in an important sense a two-dimensional exercise; it must include some degree of understanding of the factors driving both the currencies involved.
Currencies are acutely sensitive to geopolitical developments and trends in the global economy as a whole, and often respond to them in counter-intuitive ways. The Canadian dollar suffered because it was perceived as a risk-sensitive currency during the global financial crisis and the subsequent European debtcrisis. It lost about 30% of its value during the global crisis, even though the Canadian economy was one of the least affected of the advanced economies.
Even more counter-intuitive is the fact the US dollar rallied during that time, despite the fact the US was the epicenter of that crisis and its economy suffered a relatively severe recession as a result.
The choices that companies make about how to manage currency can shape their profitability in a material way. The positions they take are an intrinsic part of the functioning of their business, along with decisions about pricing, hiring and capital investments.
For that reason, deciding how to hedge foreignexchange risk is generally not equivalent to making decisions about investments in other asset classes. Those decisions are important on their own account, but they are extrinsic to a business entity, not inextricably woven into their business model in the way that foreignexchange positions usually are.
So, many businesses are confronted with a difficult dilemma: they have to develop a strategy for foreignexchange risk but typically don’t have the in-house capability to do so unaided.
Developing a Strategy: Corpay’s Role
Because managing foreign-exchange exposure can be an integral part of a business’s ongoing operations, it is paramount to take an approach that is strategic, flexible, and ongoing.
A business’s hedging should be consistent with reducing its overall level of risk and shouldn’t just transfer one form of risk for another. Hedging isn’t a form of speculation, and it should be closely aligned
to corporate cash flow.
Corpay is a bespoke provider of foreign currency trading, risk management and international payment services. We work with companies of all sizes and niches to help them execute day-to-day foreign currency transactions, as well as providing them with the tools they need to apply a unique risk management structure within their business. Typical goals of this structure are to mitigate their exposure, stabilize their cash flows, and protect their budgeted rates. We aim to deliver value by working collaboratively with our customers to identify opportunities and meet their desired business and financial goals.
As part of our process, Corpay aims to work in a consultative capacity; evaluating, managing and hedging risks in a coordinated and active way.
The role Corpay plays in helping organizations successfully manage currency risk varies depending on each individual customer’s needs, but the following section provides a broad outline of how it works.
- Identify the nature of your foreign exchange exposures
- Develop a clear and simple risk management policy
- Specify your budgeted rates and goals, and review as part of
your financial planning process
- Select tools and products that best achieve your overall goals
- Execute your strategy
- Evaluate your results and adjust your strategy accordingly
The overall approach of a strategy and the products deployed in any given situation are determined by a mix of both the budgetary parameters of what a company needs to achieve and the overall market environment. A strategy may include currency market derivatives, when appropriate. There are three types of instruments are available for hedging currency risk.
- Spot trades
Spot trades leave companies fully exposed to currency moves in either direction.
Forward (or swap)-based instruments fix an exchange rate today for delivery in the future. The cost of forwards is derived from the difference in interest rates between the two currencies being traded rather than forecasts of exchange-rate movements, and as a result can be some of the most cost-efficient and flexible financial tools in managing currency risk.
Options are specific tools that are deployed depending on the situation.
For instance, if a business is concerned about the downside risk to the US dollar or feels that the market has hit a near-term high, it could deploy a forward-like strategy to maximize the efficiency of its protection.
Another example: Let’s say a business is in a market with a risk of sustained US dollar strength, that business might make use of a zero-cost option strategy, such as a collar, that provides forward-like protection to the downside risk while still providing at least some ability to participate in a favorable markets.