Foreign exchange risk

Foreign exchange risk concerns usually with accounts payable and receivable for contracts that

are or will be in force. Constantly changing Foreign Exchange Rates forces businesses to convert

funds generated overseas at lower rates than they budgeted. That is why it is crucial that

businesses have a foreign exchange policy in place to:

 enhance cash flow control

 stabilize profit margins on sales

 simplify foreign and domestic pricing

 eliminate the negative impact of exchange rate fluctuations on sales and procurement

In order to develop a reasonable foreign exchange policy, businesses must evaluate their foreign

exchange risks, identify the tools available to hedge these risks and carry out a regular

comparative analysis to select the most effective tools.

Here are the main types of foreign exchange policies:

 Natural hedging: The business earns the majority of its revenues and expenses in the

same foreign currency but does not hedge the difference between payables and

receivables, which is known as natural hedging.

 Selective hedging: When it's impossible to foresee needs, this sort of hedging is used to

cover some foreign exchange transactions.

  Systematic hedging: This sort of hedging encompasses all foreign exchange operations

in order to prevent the impact of currency fluctuations on profit margins.

Here are the main currency hedging tools:

 Currency forward: A forward contract between two parties specifies the terms for the

sale or purchase of a certain amount of currency. In some circumstances, the contract

might be open-ended or fixed to allow for better delivery flexibility.

 Swap: A swap involves the simultaneous execution of two cross deals in equal quantities.

They are used to match foreign currency inflows and outflows on different dates, as well

as to move a currency forward or backward. A swap, for example, can be used to quickly

acquire an amount in a foreign currency to pay accounts payable in exchange for a

currency forward for currency resale when receivables are settled. Any difference in rates

will be based on the forward points and will be locked in.

 Vanilla option: A vanilla option is used to shift the risk of foreign exchange to a third

party in exchange for a premium. The company reserves the right to purchase a

predetermined amount of money from a third party on a predetermined date at a

predetermined rate. This manner, the company profits if the currency appreciates and is

protected if it depreciates. The premium cannot be refunded.

REFERENCE
https://www.desjardins.com/ca/co-opme/business/tip-sheets/global-trade-risks-how-manage-

them/index.jsp