When is FX risk a serious risk?

When is FX risk a serious risk?

When drawing up an effective FX risk policy to mitigate the transactional currency risks of a company, the definition of the objectives as well as the hedge horizon and hedge ratios are important elements.

Common objectives with regard to FX risk management are minimizing the impact of changes in FX rates on the P&L as well as minimizing the effects on cash flows. The question is how to define a policy and strategy that will result in achieving those objectives.

A common course of action is to enter into derivatives, which is fine, however there are other ways to mitigate risks. It is often ignored that fluctuations in FX rates can, to a certain extent, be passed on to suppliers and customers by adjusting product pricing in foreign currency. The extent to which this is possible depends of course on the market in which the firm operates and the level of competition.

Hedging of FX risks should be complemented with those moments when a firm can decide to adjust its price levels in foreign currency. It is the period that a price is fixed in a foreign currency or when the price elasticity is low that a firm actually runs an FX risk. This should also be the hedge horizon. Even then the fluctuations in FX rates do not necessarily have to be a risk for the company.

Some firms choose to only hedge FX risks as soon as they appear on the balance sheet. The question arises whether this is in line with the objectives of FX risk management. It could be that the price levels in foreign currency were fixated at an earlier point in time and that this leads to a certain period of risk on the margin in the P&L.

Basically it is about determining when an FX risk is truly a risk for the company. It is therefore of vital importance to start a dialogue between treasury and the business in order to establish a fit between the FX risk management activities and the business model and cycle of the firm, thus resulting in achieving the objectives of the FX risk policy. This way FX risk can, where necessary, be hedged in time and there is also the opportunity for the business to pass the FX risks on to other parties in the supply chain, if possible.