Management of Currency Exchange Risk during COVID-19

Management of Currency Exchange Risk during COVID-19

19 Jun 2020 05:01 PM
 

What is Currency Exchange Risk?

Currency exchange risk refers to the losses that can be incurred in an international financial transaction due to fluctuations in the currencies involved. Any appreciation/depreciation in the base currency or the denominated currency will affect the cash flows arising from that transaction.

How does currency exchange risk affect Importers and Exporters?

Exporters: An exporting company is exposed to currency exchange risk when it sells a product to a company based in another country. The risk is that when the time of payment arises, the value of the foreign currency, in which the payment is denominated, might depreciate leading to a lower payment to the exporting firm.

Importers: An importing company is exposed to currency exchange risk when it buys a product from a company based in another country. The risk is that, when the time of payment arises, the value of the foreign currency, in which the payment is denominated, might appreciate leading to a higher payment from the importing firm.

Point to note: The currency fluctuations can happen in favorable direction too. In case of an Exporting company, the foreign currency can appreciate and for an importing company, the foreign currency can depreciate. This makes it appealing for the domestic company to do nothing about the foreign exchange risk and stay exposed to it. And assume that by ignoring the risk, eventually, all the gains and losses will balance out.

Implicit Costs of Ignoring Currency Exchange Risk

There are many variables that can influence the value of a nation’s currency, including interest rates, inflation, the economy, balance of trade between the two countries, and political instability. In reality, one has no control over any of these variables- an exchange rate can fluctuate at any time. Thus, currency exchange rates are often said to follow a “Random walk”. These fluctuations can be drastic in turbulent times like we’ve seen during this coronavirus pandemic.

Management of exchange rate risk is very important to protect the business from unplanned losses. Even if one wins in the gamble sometimes.  Especially for small companies, there is no surety on what profit will be the next transaction for, and how much cash flow will be left to fulfill the next contract. The cost of this uncertainty is massive. The cash flow gets considerably affected by currency exchange risk.

Management of Currency Risk

Management of currency risk can help stabilize the cash flows and reduce the uncertainty attached to it. To manage the currency risk, there are two types of contracts in the FX market: FX Forward contracts and FX Options:

  • FX Forward Contracts: It is an agreement between the two parties to exchange two designated currencies at a predetermined rate, on a specific date in the future. These contracts take place after the spot contract settles and are used to protect the buyer of the contract from any fluctuations in currency prices. These contracts are binding, and cannot be withdrawn from. The added risk in these contracts is that if on the forward maturity date the currency which the exporter/ importer was hedging against, moves in a favorable direction- the exporter or importer has to make the payment at the predetermined rate. FX Forward Contracts are the most widely used instruments for currency exchange risk management.
  • FX Options: Unlike an FX Forward, an FX option is not binding in nature. One has the right, but not the obligation, to buy/sell the foreign currency on a future date at an exchange rate guaranteed in the option contract. The option lies with the buyer of the FX Option Contract. In this way, the option contract helps to protect from the downside risk while retaining the upside potential, in case of any favorable movements in the exchange rate. A disadvantage of using FX Options is that, unlike FX Forward contracts, an upfront premium is to be paid to buy the Option contract. However, they can be used with other strategies to minimize the premium cost.

How to handle the ups and downs during COVID-19?

Management of Currency Exchange Risk is of paramount importance during turbulent times, like this pandemic. The currency fluctuations are very volatile and cannot be predicted as the circumstances are uncertain. Businesses are already suffering, and cannot afford to lose much on cash flows due to exchange rate fluctuations.

Thus, there is a profound need to stabilize these cash flows using one, or a combination of contracts. One should know when, how and by what amount should they hedge the currency risk. Along with that, they also have to decide on which contracts to use. By using the contracts, an exchange rate is locked in for a future date, which makes the cash flows fairly predictable in these unpredictable times. This further helps in future planning, budgeting and increases liquidity.

Since there are many variables to be looked at, it is favorable to take suitable advice from an FX expert rather than just speculating the currency movements and hedging based on them. Myforexeye provides a combination of many foreign exchange related services. Their Forex Risk Advisory service helps the clients to hedge in an effective manner- preventing losses at minimum cost.

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