FITTskills™ Lite

Analyzing and Mitigating

Currency/Foreign
Exchange Risk
World Leader in International Trade Training and
Certification
The Forum for International Trade Training (FITT) is committed to advancing
the profession of international trade by providing training, certification, and
resources for individuals and businesses seeking growth in global markets.

FITT is a not-for-profit organization dedicated to fostering a community of

practice for international trade practitioners to support the growth of global
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government. Our international business solutions, the FITTskills training program
and CITP®|FIBP® designation, are a standard of excellence for individuals and
organizations around the world.
FITTskills™ Lite
Analyzing and Mitigating
Currency/Foreign
Exchange Risk
FITTskills™ Lite: Analyzing and Mitigating Currency/Foreign Exchange Risk

ISBN 978-1-988782-90-4

Printed 2023

Copyright © 2017, 2019, 2020, 2021, 2023 FITT

All rights reserved. The reproduction, storage in a retrieval system or transmission in any
form or by any means (including electronic, mechanical, photographic, photocopying
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FITT (Forum for International Trade Training Inc.) is an infringement of copyright law.

For information contact FITT:

P: 613.230.3553 or 800.561.3488
E: info@fitt.ca
W: EDC-FITT.com

Disclaimer
Every reasonable attempt has been made to contact the copyright owners of
information and sample documents included in this textbook. If a copyright owner
observes that permission was not obtained, he or she should advise FITT of this in
writing so that permission can be properly acknowledged in future publications.

While FITT has made every reasonable attempt to provide accurate information, this
information may contain errors or omissions for which FITT disclaims any liability.

The opinions and interpretations in this publication are those of the author and do not
necessarily reflect those of the Government of Canada.

Available in French under the title « FITThabiletés™ allégée : Analyse et atténuation des
risques de change ».

This project is funded in part by the Government of Canada’s

Sectoral Initiatives Program.
Contents
Getting Started ���������������������������������������������������������������������������������������������������������������� vii
Foreword ���������������������������������������������������������������������������������������������������������������� vii
FITTskills Lite �������������������������������������������������������������������������������������������������������vii
FITTskills Program ����������������������������������������������������������������������������������������������vii
Background: Feasibility of International Trade ������������������������������������������������� x

Analyzing and Mitigating Currency/Foreign Exchange Risk ����������������������������������� 1

Introduction ������������������������������������������������������������������������������������������������������������� 2
Learning Outcomes ������������������������������������������������������������������������������������������������ 3
Reflect on Your Experience ���������������������������������������������������������������������������������� 3

Analyzing and Mitigating Currency/Foreign Exchange Risk �������������������������� 5

Why Is This Important? �������������������������������������������������������������������������������������� 5
What Is Currency/Foreign Exchange Risk? ��������������������������������������������������� 6
The Risk Management Process and Currency/Foreign Exchange Risk � 6
Reviewing Currency/Foreign Exchange Risk Data ��������������������������������������7
The Reference Rate of Exchange ������������������������������������������������������������������� 9
Measuring Sensitivity of Profit Margins to FX Fluctuations ��������������������� 10
Identifying the Time Horizon ��������������������������������������������������������������������������11
Calculating an Organization’s FX Position �������������������������������������������������� 13
Mitigating FX Risk Through Hedging Strategies ���������������������������������������� 15
Managing Settlement Dates with FX Swaps ����������������������������������������������� 18
The FX Hedging Ratio ��������������������������������������������������������������������������������������20
Approaches to FX Hedging ���������������������������������������������������������������������������� 21
Solutions Other Than Hedging Instruments ���������������������������������������������� 22

© FITT i
 Formulating a FX Policy �����������������������������������������������������������������������������������24
Implementing and Monitoring an FX Policy �����������������������������������������������26

Summary ��������������������������������������������������������������������������������������������������������������������������27
Apply Your Learning �����������������������������������������������������������������������������������������29
Extended Learning ��������������������������������������������������������������������������������������������30
Apply Your Learning - Answers ��������������������������������������������������������������������� 31

Notes ��������������������������������������������������������������������������������������������������������������������������������33

ii © FITT
Acknowledgements
FITT would like to thank Leroy Lowe, CITP, for the development of this
publication. This publication features content from the FITTskills Feasibility of
International Trade, Edition 7.3 textbook.

FITT wishes to express its sincere appreciation to the many industry professionals
who contributed directly and indirectly to the development and publishing of
FITTskills Seventh Edition and associated editions.

Through the efforts of the FITT Content Advisory Panel, Certified International
Trade Professionals (CITP®|FIBP®) and Emerit Consulting, FITT has published
the FITTskills Seventh Edition to correspond to the updated CITP®|FIBP®
competencies that define the expected standard of a fully proficient
international trade practitioner. Updates to Edition 7.3 continue to align with
these competencies.

FITT Content Advisory Panel

The 7.3 edition would not have been possible without the input and validation of
the FITT Content Advisory Panel:

• Leroy Lowe, CITP, Nova Scotia Community College (Panel Chair)

• Mike Au, CITP, Acsenda School of Management
• Maxim Berdichevsky, CITP, Global Affairs Canada
• Melissa Coombs, CITP, Government of Newfoundland and Labrador
• Peter Kucherepa, CITP
• Lora Rigutto Vigliatore, CITP, Forum for International Trade Training
• Zeeshanali Fazal, CITP, Export Development Canada
• Jim Wyer, CITP, Seneca Polytechnic
• Renata Kobe, CITP

Subject Matter Experts

In addition to the hundreds of subject matter experts who contributed to the
previous FITTskills editions, FITT wishes to thank the following industry specialists
and experts for their major input in the process for the review and update of the
FITTskills Seventh Edition:

© FITT iii
 • Albert Knab, CITP, Fanshawe College
• Alberto Quiroz, CITP
• Alexander R. Malaket, CITP, Opus Advisory Services International Inc.
• André Roberge, CITP, ACCIE S.A. Inc.
• Ann Archer, CITP, General Dynamics Land Systems - Canada
• Barry Diamond, CITP, Frontline Focus Global Solutions
• Becky DeStigter, CITP, The International Entrepreneur
• Brent McNiven, CITP, XPM Global Consultants
• Brian Pinkowski, International Legal & Commercial Consulting, LLC
• Callum Makkai
• Charles Janthur, CITP, Money Market Deposit Agency of Canada Inc.
• Craig A. Atkinson, CITP, Lexmerca International Trade
• Daniela Diaconu, CITP, Chartered Professional Accountants of Canada
• David Gamble, CITP, Bean Wizard Solutions
• David Wallace, CITP, DHWallace and Associates Ltd
• Deborah Youden, CITP, International Business Consultant
• Derek Polman-Tuin, CITP, Finning International
• Diane Girard, CITP, Global Links Network Inc.
• Doreen Conrad, CITP, Trade in Services Consultant
• Emiliano Introcaso, CITP, Seneca College
• Ennio Vita-Finzi, CITP, The Phoenix-Paragon Group
• Floyd Simpkins, CITP, Simcor Solutions Inc.
• Gordon Ham, CITP, Infinitum Consulting Inc.
• Guillermo Larios, CITP, Anáhuac University
• Harmeet Kohli, CITP
• Helen Graham, CITP, Nova Scotia Community College
• Hiwot Regasa, CITP
• Jamie Huget, CITP, Global Affairs Canada

iv © FITT
• Jason Santos, CITP, Copula Trade
• Jim Clark, CITP, Canada Border Services Agency
• Joshua Hodgson, CITP, Global Affairs Canada
• Katy Baker, CITP, Trade Research & Development
• Kenneth Cheng, CITP, The Poverty Game
• Kevin Duncan, CITP, NOVA Chemicals Canada
• Khawar Nasim, Global Affairs Canada
• Kumar Varma, CITP
• Leroy Lowe, CITP, Nova Scotia Community College
• Les Arany, CITP, Arany and Team Consulting and Coaching
• Lora Rigutto Vigliatore, CITP, LRV International Trade Consulting
• Manly Sitter, CITP, C-link Airline Solutions Ltd.
• Maxim Berdichevsky, CITP, Global Affairs Canada
• Melissa Coombs, CITP, Government of Newfoundland and Labrador
• Michael Schwartz
• Michelle Criger, Canadian Society of Customs Brokers
• Mike Au, CITP, Acsenda School of Management
• Murray E. Morgan, CITP
• Norman Lomow, CITP, Algonquin College
• Paula (Lunn) Greene, CITP, Beyond Ventures Group Inc.
• Pernille Fischer Boulter, CITP, Kisserup International Trade Roots Inc. &
Europe
• Perry Woods, CITP, General Dynamics Land Systems - Canada
• Peter Kucherepa, CITP
• Rachid Denane, CITP, LaSalle College
• Raymond Joyce, CITP, The Joyce Group Inc.
• Renata Kobe, CITP, St. Clair College
• Richard Game, CITP, Evans Consoles Corporation

© FITT v
 • Richard Takai, Central Okanagan Economic Development Commission
• Rick Cleveland, Supply Chain Management Association
• Sandra Macias, CITP, Panalpina
• Shahed Aziz, CITP, Scotiabank
• Shelley Gares, Canadian Society of Custom Brokers
• Sonia Mancuso Root, CITP, Agrisource Food Products Inc.
• Sonya Jenkins, CITP, Animal Nutrition Association of Canada
• Stéphane Duranleau, CITP, DuranleauLegal.ca
• Stephanie Kam, CITP, Nossaman LLP
• Susanne Knobloch, CITP, Global Affairs Canada
• Suzanne Cascanette, CITP, Kintetsu World Express (Canada) Inc.
• Terry Volpel, ISM-Canada
• Thoai Hoang, CITP, Hydrogenics Corporation
• Trish Tully, CITP, Survival Systems Limited
• Valerie Anka, Export Development Canada
• William Kosar, CITP
• Zeeshanali Fazal, CITP, Export Development Canada

FITT also recognizes the major contribution of the Government of Canada’s

Sectoral Initiatives Program (SIP), a division of Employment and Social
Development Canada (ESDC), for the development of the Seventh Edition and its
support in our efforts to assist international business practitioners in becoming
effective players in the international economy.

vi © FITT
Getting Started
Foreword
Export Development Canada (EDC) and the Forum for International Trade
Training (FITT) have collaborated to create the EDC-FITT International Trade
Learning Centre. The Centre pairs FITT's internationally renowned FITTskills
Program with EDC's trade expertise to equip import-export professionals with
the knowledge and skills they need to succeed internationally.

FITTskills Lite
As part of this collaboration, EDC and FITT published the FITTskills Lite series
to support the development of high performers in global markets. The series
uses existing FITTskills curriculum as its foundation, and provides international
business professionals with essentials that can be consumed in less than an
hour.

Select units from the FITTskills Program have been published under the FITTskills
Lite series as stand-alone knowledge offerings. The series provides learners
quick access to essential, practical and reliable knowledge in international
trade, while providing individuals with an introduction to the depth of content
available within the complete FITTskills Program. Unlike the FITTskills courses
and modules (workshops), there are no examinations for the FITTskills Lite
series, thus no FITT credentials are offered upon completion of the Lite series.

FITTskills Program
Aligned with industry-validated competency standards, FITTskills is a
comprehensive program organized into six independent courses, which
are further divided into modules (workshops), and then organized into units.
Each section provides targeted source of knowledge, skills and performance
requirements for practitioners in the current global business environment.

© FITT vii
Feasibility of International Trade

The FITTskills Program is designed and developed by international trade

practitioners who are experts in their field, meets the standards of excellence in
the field of international trade, and addresses essential topics within the context
of global trade. The content is international in scope, applying to individuals
working and/or studying in international trade regardless of what country they
reside in. There are entry points into the program for individuals and all sizes
of businesses undertaking international trade activities—whether engaged in
foreign investment or the import-export of products or services.

While each course and module (workshop) stands alone, completing the full
FITTskills Program and the respective assessments will lead to FITT credentials,
and satisfy the educational requirement of the Certified International Trade
Professional (CITP®|FIBP®) designation.

The six courses and 17 modules (workshops) are:

FEASIBILITY OF INTERNATIONAL TRADE

∙ Situational Analysis: Determining Current State and
Opportunities for Growth
∙ Cost and Pricing Analysis: Analyzing the Numbers
∙ Risk Analysis and Management: Analyzing and Mitigating Risks
in International Trade

INTERNATIONAL MARKET ENTRY STRATEGIES

∙ Planning for International Market Entry: Making Choices and
Establishing the Route to Global Success
∙ Implementation of Market Entry Strategies: Building an
International Business Operation
∙ Law and Ethics: Practical Requirements for International
Trade
∙ Intercultural Competence: Gaining New Perspectives

viii © FITT
 Getting Started

GLOBAL VALUE CHAIN

∙ International Procurement: Purchasing and Outsourcing in
the Global Marketplace
∙ Inventory Management: Maximizing Efficiency in Global
Inventory Management
∙ International Distribution: Transportation of Goods and
Delivery of Services
∙ Document Management: Control, Compliance and
Consistency

PRODUCTS AND SERVICES FOR A GLOBAL MARKET

∙ Product Development: From Idea to International
Marketplace
∙ Service Development: International Trade in Services

INTERNATIONAL TRADE FINANCE

INTERNATIONAL SALES AND MARKETING

∙ Marketing Products and Services: Attracting International
Customers
∙ Selling to International Markets: Sales Channels, Negotiation
and Follow-Up
∙ E-Commerce: Using Digital Technology to Access
International Markets

© FITT ix
Feasibility of International Trade

Background: Feasibility of International Trade

This publication features content from the FITTskills Feasibility of International
Trade, Edition 7.3 textbook. The complete course examines what individuals in
organizations need to know and do to ensure the success of new international
ventures. Careful research, analysis and planning are necessary to examine the
organization’s current state, to identify promising opportunities and to analyze
potential outcomes, both positive and negative.

For more information on this course or to view our complete list of international
business courses and workshops, please visit EDC-FITT.com.

x © FITT
Analyzing and
Mitigating Currency/
Foreign Exchange
Risk

© FITT 1
Feasibility of International Trade

Introduction
Practitioners operating in areas of uncertainty use risk management as a
structured way of avoiding, reducing or managing events that can damage
their organization. By using standard tools and strategies, decision makers can
estimate the likelihood of different types of risk and prepare contingency plans
for dealing with them.

Risk is the possibility that an event or series of events will adversely affect the
operations of an organization. Risk is measured in terms of the cumulative
probabilities that none, some or all of these events will occur. It is managed by
identifying, assessing and responding to the possibility of these events through
a systematic plan and the implementation of mitigation measures.

Risk management focuses on a wide range of important variables that can have
a negative impact on the business (e.g. physical risks, legal risks, financial risks,
technology risks, political risks, etc.). The objective of risk management is to
reduce the level of risk to an acceptable level. To make the task even more
daunting, organizations must also prepare for intangible risks, such as risks related
to poor performance, project mismanagement and/or deficient knowledge.

In international business, currency exchange rate fluctuations result from global

currency trading and this creates an ongoing degree of uncertainty and risk that
is inherent in many international financial transactions. Accordingly, this Unit
focuses on currency/foreign exchange risk as one important area within the risk
management portfolio.

Companies need to recognize currency/foreign exchange risks and then use

a formal risk management process to ensure these risks are mitigated. This
involves reviewing currency/foreign exchange risk data, measuring the
sensitivity of profit margins to foreign exchange fluctuations, identifying the time
horizon associated with exposed transactions, and calculating the organizations
overall risk exposure and financial position. These risks can be managed
using hedging strategies, financial swaps and a number of other approaches.
Ultimately, companies need to formulate a foreign exchange policy that can be
implemented, monitored and managed on an ongoing basis.

2 © FITT
 Analyzing and Mitigating Currency/Foreign Exchange Risk

Learning Outcomes
Upon successful completion of this Unit, the individual will be able to do the
following:

1 | Explain how the risk management process can be applied to the

management of currency/foreign exchange risks for an international
trade initiative.
2 | Analyze currency/foreign exchange risks for an international trade
initiative.
3 | Select from a number of currency/foreign exchange risk mitigation
strategies to choose the most appropriate tool for an organization’s
circumstances.
4 | Formulate a foreign exchange policy that can be implemented, monitored
and managed on an ongoing basis.

Reflect on Your Experience

Reflect on your past experiences and answer the following questions to the best
of your ability. After completing this Unit, review your answers to see how your
understanding of risk analysis has evolved.

1 | What are the steps in the risk management process?

2 | Which financial hedging instrument is most widely used to mitigate foreign
exchange risk and why?
3 | What are currency/foreign exchange rate fluctuations and how do you
think these fluctuations might impact international business?

© FITT 3
ANALYZING AND MITIGATING
CURRENCY/FOREIGN EXCHANGE
RISK1
To simplify the text in this Unit, currency/foreign exchange will
also be referred to as foreign exchange or FX.

Effectively managing FX risk increases the predictability of profits

and cash flow, ultimately improving competitiveness, because a
sudden unfavourable fluctuation can sharply reduce profitability.

Why Is This Important?

The volatility of currency/foreign exchange is considered to be the number one
constraint to export growth. Taking a measured approach to managing exchange
rate fluctuations can help to minimize their impact on profit margins, facilitate
the pricing of products sold or purchased in the international marketplace, and
protect an organization’s overall competitiveness.

Most organizations are aware that currency/foreign exchange fluctuations can

sharply reduce their profit margins. However, there are few that have a strategy
in place to analyze and manage this risk. Although some organizations consider
this risk to be simply a consequence of doing international business, it is possible
to reduce or transfer this risk through the development of a foreign exchange
(FX) policy. While it is a demanding undertaking, it is crucial for organizations
involved in foreign trade.

© FITT 5
Feasibility of International Trade

What Is Currency/Foreign Exchange Risk?

For organizations that sell their goods and services internationally and get paid
in a foreign currency, foreign exchange risk is the likelihood that an adjustment
of exchange rates will result in the organization receiving a lower amount of
their own currency than originally anticipated. For organizations that import and
pay foreign suppliers in foreign currency, it is the likelihood that a change in
exchange rates will mean the organization will have to pay more than planned.
This form of foreign exchange exposure, which impacts the company’s cash
flow, is commonly referred to as transaction exposure.

Other forms of exposure also exist, such as accounting/translation exposure

and economic exposure:

• Accounting/translation exposure applies when assets and liabilities

denominated in a foreign currency need to be converted for accounting
purposes. The conversion normally results in foreign exchange gains or
losses. This is of particular concern to organizations that have foreign
subsidiaries but can also impact organizations that export and import.
• Economic exposure relates to the overall impact that exchange rate
fluctuations can have on the value of an organization. Organizations
that only sell domestically can also face economic exposure when, for
example, the currency strengthens and improves the competitive position
of foreign producers.

For most organizations, managing foreign exchange risk centres on how to

mitigate transaction exposure.2

The Risk Management Process and Currency/

Foreign Exchange Risk
While the risk management process applies to considering and managing all
risk factors, the same process can be applied to each risk topic during the
development of the overall risk management plan. For instance, the steps can
be applied to the topic of currency/foreign exchange risk:

6 © FITT
 Analyzing and Mitigating Currency/Foreign Exchange Risk

Figure 1.1 – Managing Currency/Foreign Exchange Risk

1
Identify issues and set context
Practitioners review data related to foreign currencies
and establish their current position.

Identify key risks and measure probability and impact

2+3
Practitioners calculate their transaction exposure, which includes:
• Selecting the reference rate of • Measuring sensitivity of profit
exchange margins to foreign exchange
• Identifying the time horizon risk

Rank potential risks and specify desired outcomes

4+5 Practitioners examine how the possibility of currency fluctuations

affects their business plans and determine their current foreign
exchange position.

Develop options and select a strategy

6+7 Practitioners decide whether to proceed with a venture and

identify the strategies or financial instruments they will use to
mitigate risk if they proceed. These choices are formalized in a
foreign exchange policy.

Implement the plan and monitor, evaluate and adjust

8+9 Practitioners implement the foreign exchange policy and complete

ongoing monitoring and adjusting, such as the purchase of
additional financial instruments as needed.

Reviewing Currency/Foreign Exchange Risk

Data
Before calculating the potential of risk and establishing mitigation strategies,
practitioners should establish some baseline data. Prior to developing a risk
management plan, an organization should determine whether it is ready to take
on a new venture and should have conducted research into the target market(s).

For more information on the research process, see the module

(workshop) Situational Analysis in the course Feasibility of
International Trade.

© FITT 7
Feasibility of International Trade

As a result of this research, the organization will have up-to-date information

regarding the target market’s currency. This information can include the
following key facts:

• Current volatility • Historic trends of fluctuating

• Strengths and weaknesses value

This information provides a foundation of understanding for the analysis of

an organization’s foreign exchange position. Exchange rate forecasts may be
available but should be interpreted with caution.

The Reliability of Exchange Rate Forecasts

Exchange rate forecasts are commonly available from banks, foreign exchange
brokers and online sources. Some forecasts are more general and deal with the
long term, while others are very specific and look at the immediate future. The
type of analysis used to produce these forecasts usually falls into one of two
categories:

1 | Fundamental analysis: based on economic parameters, such as Gross

Domestic Product, unemployment, inflation and interest rates.
2 | Technical analysis: based on the study of the past evolution of exchange
rates.

Most exchange rate forecasts are well documented and rigorous, but remain
fallible depending on the circumstances since so many competing variables are
involved.

Experts may have a sense of exchange rate directions but most are unable to
consistently predict how exchange rates will evolve in the short, medium and
long term. Basing decisions about foreign exchange risk management on such
predictions can thus be a source of additional risk for an organization. This risk
should never be accepted unless the organization has the financial ability to
withstand a possible deterioration of its cash flow and profit margin due to
exchange rate movements.

There are no shortcuts to analyzing and mitigating currency risk and no

practitioner should rely entirely on published data. Every organization and
venture is unique and needs to be considered separately. As well, once

8 © FITT
 Analyzing and Mitigating Currency/Foreign Exchange Risk

established, foreign exchange policies must be monitored and adjusted to

changing conditions.

The Reference Rate of Exchange

FX risk is present from the moment the selling price of the goods or services is
established. The rate of exchange used to calculate this is called the reference
rate of exchange or, more simply, the reference rate. For example, consider
a fictional Canadian company called BEDM Systems Inc. (BEDM), which has
customers in the United States. It manufactures and exports a product that has
to bring in CAD 100 per unit in order to make a sufficient profit.

Suppose also that the rate of exchange is USD/CAD 1.0525 at the time BEDM
calculates its export price. In this case, the product’s unit selling price in the
U.S. should be USD 95 (1.0525 x USD 95 = CAD 100). In other words, for BEDM
to achieve its desired profit, each dollar of U.S. revenue must be converted to
1.0525 Canadian dollars. The reference rate is thus USD/CAD 1.0525.

If BEDM sells its U.S. dollars at a rate that is less than the reference rate, its profit
margin will be lower than expected and it will suffer an FX loss. Conversely, if
the exchange rate at which the company sells its U.S. dollars is more than the
reference rate, BEDM’s profit margin will increase and it will generate an FX gain.

The concept of reference rate is found in all export markets. For example, if
BEDM sells the same product in Spain for EUR 77, the reference rate is then EUR/
CAD 1.2987, since EUR 77 x 1.2987 = CAD 100.

Selecting the Reference Rate

The reference rate must reflect the market exchange rate in effect when the
selling price in a foreign currency is calculated. In order to effectively mitigate
most or all of the FX risk by purchasing FX hedging instruments, it should be done
when the actual market rate of exchange is at or very close to the reference rate.

© FITT 9
Feasibility of International Trade

Measuring Sensitivity of Profit Margins to FX

Fluctuations
To illustrate how to measure FX risk, we’ll return to the example of BEDM. The
company is aiming for a gross margin of 30 percent on each unit sold, and its
revenue and margin figures include the following characteristics:

• Selling price USD 95.00 • Anticipated gross margin

CAD 23.08
• Expected revenue CAD 100.00
• Unit cost CAD 76.92
• Anticipated gross margin
30 percent

Using this information, we can analyze the sensitivity of BEDM’s profit margins
to exchange rate fluctuations, as shown in Table 1.1.

Table 1.1 – Sensitivity of BEDM’s Profit Margin to Exchange Rate Fluctuations

Variation Variation
USD/CAD FX Gain Profit Profit in rate of in profit
exchange Unit price Revenue / Loss in margin in margin exchange margin
rate in USD in CAD CAD CAD in % (%) (%)
1.1600 95.00 110.20 10.20 33.28 43.3 30.2 44.3
1.1200 95.00 106.40 6.40 29.48 38.8 27.2 27.7
1.0800 95.00 102.60 2.60 25.68 33.4 25.0 11.3
1.0525 95.00 100.00 0.00 23.08 30.0 23.1 0.0
1.0400 95.00 98.80 (1.20) 21.88 28.5 22.1 -5.0
1.0000 95.00 95.00 (5.00) 18.08 23.5 9.0 -21.7
0.9600 95.00 91.20 (8.80) 14.28 18.6 15.7 -38.0
0.9200 95.00 87.40 (12.60) 10.48 13.6 12.0 -54.7

As the bottom row of Table 1.1 shows, an unfavourable change of 12.6 percent
in the USD/CAD exchange rate (from 1.0525 to 0.9200) causes a 54.7 percent
deterioration in BEDM’s profit margin, which drops from CAD 23.08 per unit to
CAD 10.48 per unit. The other rows of the table show how the profit margin
changes as the exchange rate varies from 1.1600 to 0.9200.

This analysis has been simplified by dealing with a single product, by generating
all revenues in USD and by having all unit costs in CAD. For most organizations,
the real-world analysis of FX risk is considerably more complicated, since it

10 © FITT
 Analyzing and Mitigating Currency/Foreign Exchange Risk

involves many different products, as well as revenues and expenditures in

various currencies.

This should not, however, prevent an organization from carrying out the more
complex analyses that will measure the sensitivity of profit margins to exchange
rate fluctuations. To do so, a different table for each of the currencies in which
it earns revenue must be prepared. Then the FX gains and losses, as well as the
profit margin, need to be calculated by factoring in the impact of exchange rate
fluctuations on the portion of unit costs that are payable in foreign currency.

Identifying the Time Horizon

The time horizon is the period during which the organization does not change
its reference rate and thus commits to a selling price. The time horizon can
vary considerably from one business to another based on the nature of the
goods and services sold, as well as an organization’s marketing strategies. Some
organizations mitigate their FX risk by regularly revising their reference rates and
thereby adjusting their export selling prices. This establishes a relatively short
time horizon. At the extreme, when an organization adjusts its selling price
with every order, the time horizon shrinks to zero. Regardless of the constant
volatility of exchange rates, however, most organizations need to honour their
sale prices for a minimum period of time. Publishing a price list or submitting
a proposal, for example, indicates such a commitment and thus establishes a
time horizon. Few companies can make up for FX fluctuations by adjusting their
prices during this period.

Any project with scheduled payments or completion two years or

more in the future merits a detailed study with financial projections
using different exchange rates and should include the cost of
hedging to ensure the profit that is expected at the completion of
the project or at the time the invoice is paid is maintained.

Unconfirmed FX Risk
Most companies find themselves in a situation where FX risk is present even before
a single sale is finalized. In this case, FX risk is described as being “unconfirmed”.

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Feasibility of International Trade

It will only become a “confirmed” FX risk when a sale is completed and the
company is assured of receiving a payment in a foreign currency. Unconfirmed
FX risk is a genuine type of risk. It should be acknowledged and managed as soon
as it appears. The difficulty with this is that the level of sales and the amount of
FX risk is not yet known.

Measuring Unconfirmed FX Risk

The importance of measuring unconfirmed FX risk varies according to the
situation. Submitting a proposal and establishing a price list are two such
situations.

Bidding on a Project
When an organization submits a price for a project bid in a foreign currency, it
is often impossible to determine the percentage likelihood that it will eventually
make the sale. Because of this uncertainty, the unconfirmed risk cannot be
accurately measured, which makes it hard to manage the FX risk related to this
potential sale.

One possible solution is for an organization to try to negotiate a risk-sharing

provision with the foreign buyer but buyers are rarely receptive to this approach.
Moreover, drafting such a provision at the proposal stage can be quite complex
and the results may still not effectively protect the organization’s profits.

Another alternative could be to purchase an FX option. FX options have features

that can make them useful for mitigating FX risk when a company bids on a
project where payments will be made in a foreign currency. In Canada, for
example, only a limited number of businesses choose this approach since
FX options are often perceived to be expensive. Furthermore, the bidding
process regularly extends well beyond the initial deadline, which can make it
difficult to select the expiry date for the option.

Publishing an Export Price List

Publishing an export price list implies a commitment to honour prices within
a specific time horizon. Market studies and sales figures for previous years can
help in assessing the potential export sales during this period. This data makes it
possible to measure an organization’s exposure to unconfirmed FX risk.

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 Analyzing and Mitigating Currency/Foreign Exchange Risk

To return to the example of BEDM Systems, suppose the company tells its U.S.
customers that its prices are valid for the next 12 months. This means that BEDM
now knows its first two FX risk parameters. They are the reference rate of USD/
CAD 1.0525, which was used to calculate the unit selling price of USD 95, and
the time horizon of 12 months.

To measure its unconfirmed FX risk, BEDM still needs a figure for its potential
future sales. Based on previous performance, it estimates that it will sell
between 150,000 and 170,000 units in the United States within the 12-month
time horizon. The company can now calculate its unconfirmed FX risk as being
between USD 14.25 million (USD 95 x 150,000) and USD 16.15 million (USD 95
x 170,000).

Confirmed FX Risk
Confirmed FX risk is easier to identify, measure and manage than unconfirmed
FX risk. This is because, for each foreign currency transaction, there are known
elements such as those listed below:

• Accounts receivable • Organization purchase or sale

orders
• Accounts payable
• FX forward contracts
• Cash on hand

Confirmed FX risk depends on elements that are easily identified and measured,
as opposed to unconfirmed FX risk. Consequently, the estimate of confirmed FX
risk does not depend on assumptions about sales that may or may not occur.

Calculating an Organization’s FX Position

The measurement of both unconfirmed and confirmed FX risk involves
calculation of an organization’s total exposure to FX risk. This is also known as
the FX position. A simple way to calculate the FX position is to complete a table
such as the one below. A table needs to be prepared for each of the foreign
currencies in which an organization carries out transactions.

Table 1.2 shows the FX position calculations for BEDM’s U.S. dollar transactions.
Note that receipts are on the plus side, while disbursements and FX forward
sale contracts are on the minus side. Importantly, currency flows are recorded
regardless of their expected collection or disbursement dates. BEDM has an

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Feasibility of International Trade

overall FX position of USD 12,515,000. This is made up of USD 6,405,000 of

confirmed exposure, plus USD 11,510,000 of unconfirmed exposure, minus
USD 5,400,000 in FX forward contracts that BEDM is already using to hedge
some of its FX risk. Based on this FX position, the positive or negative impact on
BEDM’s cash flow and profits will be CAD 125,150 for each change in the value
of the U.S. dollar of CAD 0.01. In other words, a one cent fluctuation in the USD/
CAD rate of exchange will cause a profit or loss of CAD 125,150.

Table 1.2 – BEDM’s FX Position

Foreign exchange position in USD

Confirmed exposure
Cash 240,000
Accounts receivable 1,275,000
Firm orders – sales 6,400,000
Accounts payable (210,000)
Firm orders – purchases (1,300,000)
Other confirmed receipts 0
Other confirmed disbursements (0)
Confirmed exposure 6,405,000
Unconfirmed exposure
Expected sales 14,250,000
Expected purchases (2,740,000)
Other expected receipts 0
Other expected disbursements (0)
Unconfirmed exposure 11,510,000
Total exposure 17,915,000
Foreign exchange contracts
FX forward contracts used to sell U.S. dollars (5,400,000)
Foreign exchange position 12,515,000

By calculating its FX position, an organization can clearly identify the impacts of

FX risk. Organizations use this information to make business planning decisions
and to determine if a new venture is feasible. They will analyze the potential

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 Analyzing and Mitigating Currency/Foreign Exchange Risk

outcomes and relate them to their overall business plan and internal risk
tolerance.

As depicted in Figure 1.1, once the data is collected and analyzed, there is a
decision point (Step 6: Develop Options). At this point, an organization can
choose from the following options:

• Risk avoidance, e.g. choose not to pursue a particular market

• Risk transfer, e.g. use a hedging strategy
• Risk retention, e.g. choose to move forward and accept the potential
outcomes

If the organization chooses risk transfer, it will pursue strategies to mitigate its
risk.

Mitigating FX Risk Through Hedging

Strategies

If FX risk is poorly managed by not hedging at all, speculating and/

or over-hedging, it can have important financial repercussions:

1 | If a company is speculating and does not hedge, it is fully

exposed to large swings in the exchange rate and it could
suffer significant losses.

2 | If a company is over-hedged it does not have the assets to

settle its open positions.

However, the actual success or failure of an organization will be

due to things like liquidity, new business, leverage, etc.

Many organizations do not select their reference rate of exchange, their time
horizon or calculate their FX position. As a result, they may develop their hedging
strategy on the basis of an inaccurate idea of what their FX position actually
is. These organizations proceed directly into purchasing hedging products or
other mitigating strategies that may not be effective for their actual position. It

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is important that the organization’s FX position is identified accurately before

moving on to choosing mitigation strategies.

Once an organization knows its FX position, it will develop a hedging strategy

which involve the following practices:

• Selecting hedging instruments • Choosing hedging techniques

• Setting a hedging ratio

The FX market offers two hedging instruments to consider: FX forward contracts

and FX options.

FX Forward Contracts
An FX forward contract is an organization’s commitment to exchange
predetermined amounts of two different currencies at a future date. The rate of
exchange between these two currencies is guaranteed by the contract. Because
of this guarantee, the organization knows in advance how much of their own
currency they will receive in exchange for the foreign currency, even as the
exchange rate changes over time. FX forward contracts protect against adverse
FX fluctuations but they also prevent an organization from making any financial
gains if the exchange rate moves in a favourable direction. The FX forward
contract is widely used by many organizations because it is easy to understand
and implement, and it requires no initial outlay of cash.

FX Options
Unlike an FX forward contract, an FX option does not commit the option holder
to buy or sell a given amount of foreign currency on a specific future date.
Instead, it gives the option holder the right (but not the obligation) to do so, at
an exchange rate guaranteed in the option contract. The option holder will only
exercise this right if it suits his needs and if it is financially beneficial for him to
do so (that is, if the exchange rate guaranteed by the option is more favourable
than the market rate of exchange). FX options are therefore highly flexible. They
enable the holder to protect against FX risk while retaining the possibility of
profiting from favourable movements in the exchange rate. The drawback is
that, unlike FX forward contracts, the holder must pay an upfront premium to
purchase the option.

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FX options can be purchased from, or sold to, a banker or broker. Organizations

that seek protection against FX risk will normally buy FX options that give
them the right to sell a designated foreign currency. Selling FX options does
not protect organizations against FX risk but, instead, provides them with an
opportunity to earn a premium up front. With the exception of the FX forward
contract and a few of its variations, all other FX hedging instruments are based
on options. Through various combinations of purchases and sales, options are
used to create a wide range of hedging products that carry names such as “FX
Collar”, “FX Tunnel” and “FX Forward Plus”. Some of these products are even
structured so as to require no initial cash outlays.

FX Facilities
The FX forward market exposes the banker or broker to the risk that the exporting
company may be unable to honour its contracted FX obligations. If the business
defaults in this way, the banker or broker that provided the FX coverage may be
exposed to significant financial losses.

Bankers and brokers manage this default risk by granting FX facilities to the
exporters they support. A FX facility authorizes the exporter to buy or sell FX
forward contracts but imposes limits on the transaction amounts and the due
dates for these contracts.

To measure default risk, bankers and brokers usually apply a risk coefficient
to the amount of the FX facility. This coefficient generally ranges from 10–15
percent and is based on an assessment of the client’s credit risk and the volatility
of currency markets. Multiplying the risk coefficient (such as 15 percent) by the
amount of the FX facility (such as $500,000) gives the value for the default risk
($75,000).

Many export credit agencies, such as Export Development Canada

(EDC), provide programs and services that assist organizations
in their international business goals. For instance, EDC offers
a Foreign Exchange Facility Guarantee (FXG) that guarantees
the collateral required by many banks and FX brokers for the
purchase or sale of FX contracts. This releases an organization
from the collateral requirement, thus providing more funds for
business activities. Other agencies include Export-Import Bank of
India, Export-Import Bank of the United States, Office National
du Ducroire (Belgium) and Exgo (New Zealand).

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Feasibility of International Trade

To manage this risk, FX brokers often require the exporter to provide a deposit
as guarantee. Bankers, on the other hand, will often subtract the amount of
the default risk from their client’s total approved credit, usually by freezing the
client’s line of credit by an amount equal to the default risk. This reduces the
company’s borrowing capacity.

Managing Settlement Dates with FX Swaps

When purchasing FX coverage, a settlement date must be selected, which is
when currencies will be exchanged. It can be difficult to set the settlement date
for a FX forward contract as the date may be in the distant future. FX risk usually
arises well before the collection date of export earnings is known. By selecting
this date, an organization makes a commitment to the bank or FX broker that
a specific amount of foreign currency will be paid on that date, even if the
organization is not certain it will have the foreign currency to do so on that date.

This may seem like a risky commitment. In fact, it is quite easy to manage
situations where foreign currency payments are not received when expected.
If there are not enough foreign funds to settle a FX forward contract on the
settlement date, that settlement date can be pushed by means of a FX swap. This
technique is both straightforward and widely used. To see how a swap works,
consider again the example of BEDM Systems. The company’s FX position shows
that the business has FX forward contracts for a total of USD 5.4 million. Assume
that a contract for USD 1 million was concluded with a three-month due date.
On the due date, BEDM has not yet received the U.S. dollars needed to settle its
contract. To deal with this, it uses an FX swap to move the settlement date to a
later date. The FX swap allows BEDM to keep its FX coverage fully in place. The
visual below shows how the situation evolves using the swap.

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 Analyzing and Mitigating Currency/Foreign Exchange Risk

Figure 1.2 – Using a FX Swap to Extend a Settlement Date

T+3 Months New Settlement Date

T Initial Settlement Date T+4 Months

Initial 3 Month FX Forward Contract

For the Sale of USD

Protection Provided by the

Forward Contract
Extended by 1
Month Using FX Swap

FX Risk Covered For 4 Months

How a FX Swap Works

The swap is made up of two simultaneous transactions. First, BEDM buys the U.S.
dollars that it does not have but must deliver, through an FX spot transaction.
Then, BEDM resells U.S. dollars on a forward basis for settlement on a date that
corresponds to the company’s updated collection forecast (one month later,
in this example). Using swaps means that BEDM can cover its FX risk from the
moment it appears without having to worry about when it will get paid by its
foreign customers.

Note that FX swaps are not hedging instruments like FX forward contracts and
FX options because they do not transfer FX risk from your company to a bank
or FX broker.

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Feasibility of International Trade

FX Swaps and Natural Hedging

If a company pays its invoices and collects its export revenue in the same
currency, it is said to be using “natural hedging” to manage its FX risk. However,
collections and disbursements in the same foreign currency rarely come due
on the same date—there is generally a gap that can range from a few days to
several months.

If an organization is in this situation, the FX swap is an effective way of filling the

gap. Further, FX swaps make it possible to temporarily convert foreign currency
cash balances into the organization’s national currency without any FX risk. This
increases the availability of funds, which can help to manage cash and short
term debt.

The FX Hedging Ratio

The FX hedging ratio is the percentage of FX coverage compared to the
company’s FX position. A 100 percent ratio indicates that the FX position is
completely covered. A lower ratio indicates that a portion of the FX risk is not
hedged and, consequently, that the exporter can tolerate a certain degree of
risk. The exporter might do this to take advantage of a favourable movement in
exchange rates, for example.

Determining the coverage ratio should be done carefully since an effective

hedging strategy does not necessarily require a 100 percent ratio. However,
organizations should avoid simplistic formulas such as “businesses should cover
50 percent of their FX risk”. Each company is unique and should analyze its
hedging needs according to its individual requirements and capabilities. The
decision to set the hedging ratio below 100 percent should be based on a detailed
analysis of the potential financial losses to which the business is exposed.

Table 1.3 extends the sensitivity analysis developed for BEDM Systems to show
the effects of various hedging ratios on the company’s profit margin per unit.

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 Analyzing and Mitigating Currency/Foreign Exchange Risk

Table 1.3 – BEDM’s Profit Margin Based on Various FX Hedging Ratios

Profit margin (percentage) for
various hedging ratios with the
hedge locked in at a rate of USD /
USD / CAD FX gain / Profit CAD 1.0525
exchange Unit price Revenue loss in margin in
rate in USD in CAD CAD CAD 0% 50% 65% 80% 100%
1.1600 95.00 110.20 10.20 33.28 43.3 36.6 34.6 32.6 30.0
1.1200 95.00 106.40 6.40 29.48 38.3 34.2 32.9 31.7 30.0
1.0800 95.00 102.60 2.60 25.68 33.4 31.7 31.2 30.7 30.0
1.0525 95.00 100.00 0.00 23.08 30.0 30.0 30.0 30.0 30.0
1.0400 95.00 98.80 (1.20) 21.88 28.5 29.2 29.4 29.7 30.0
1.0000 95.00 95.00 (5.00) 18.08 23.5 26.7 27.7 28.7 30.0
0.9600 95.00 91.20 (8.80) 14.28 18.6 24.3 26.0 27.7 30.0
0.9200 95.00 87.40 (12.60) 10.48 13.6 21.8 24.3 26.7 30.0

This shows that by immediately hedging its FX risk, BEDM can reduce the volatility
in its profit margins caused by exchange rate fluctuations. The five columns on
the right show the effects of various hedging ratios when the FX hedge rate (that
is, the exchange rate at which BEDM is assured of selling its U.S. currency) is
equal to the reference rate of USD/CAD 1.0525.

Ultimately, senior management is responsible for determining what constitutes

an acceptable level of exposure to FX risk. To make this determination, they
should focus both on current attitudes toward FX risk and financial information
such as the data included in the tables addressing profit margin sensitivity and
scenarios outlining various FX hedging ratios.

Approaches to FX Hedging
There are two main ways of setting up FX hedges: the systematic approach and
the progressive approach.

Systematic Hedging
With systematic hedging, the risk is covered immediately after the FX position
has been calculated and the hedging ratio has been determined.

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Feasibility of International Trade

Progressive Hedging
With progressive hedging, risk is not immediately covered—instead a risk
tolerance threshold is established. This is an exchange rate beyond which FX
coverage is automatically put in place. When using this approach, exposure to
a certain amount of risk is accepted in the hope of that the organization will
benefit if the exchange rate moves in the organization’s favour. To do this, a loss
threshold is established and the tolerable exchange rate calculated to determine
when FX losses become unacceptable. If the rate reaches this level, FX coverage
is immediately put into place. Conversely, a profit threshold can be established.
If the rate reaches this level, thus increasing profits, FX coverage is put into place
immediately to lock in gains.

To use the progressive approach successfully, the acceptable financial risk

must be quantified using the types of profit sensitivity analyses shown the
BEDM example. This approach requires very strict discipline and must include
mechanisms to ensure that FX coverage is put in place as soon as the tolerance
threshold is reached.

Solutions Other Than Hedging Instruments

In addition to the hedging instruments provided by banks and FX brokers, there
are several other methods that exporters use to manage FX risk. These include
natural hedging, transfer of risk to the buyer, invoicing in the organization’s
national currency and raising the export selling price. None of these solutions
is without flaws and they cannot fully replace an effective use of hedging
instruments.

Natural Hedging
When a company pays its invoices and collects its export revenue in the same
currency, it is using natural hedging to manage its FX risk. In many situations,
natural hedging occurs on its own, such as when a product is priced in a foreign
currency and at least part of the production costs is invoiced in the same
currency. In other situations, natural hedging is the result of a strategic decision,
such as when an organization favours suppliers who invoice their products or
services in the currency in which foreign sales revenues will be collected.

Another form of natural hedging is to borrow in the currency in which most of

the export sales are paid. These foreign currency receipts can then be used to

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make loan repayments. The latter reduces the FX position in the same way as
accounts payable and other financial obligations in a foreign currency.

Natural hedging has considerable advantages when exchange rate fluctuations

are unfavourable but it also limits an organization’s ability to profit from
favourable fluctuations.

Transferring FX Risk to the Buyer

Contract provisions that transfer risk to the buyer are unusual since buyers are
rarely receptive to such measures and generally will not agree to them unless they
have no other choice. Risk-sharing provisions are somewhat more common (but
still the exception) and are found in cases where the exporter and the importer
agree to split the financial consequences of exchange rate movements. These
provisions are not a form of exchange rate coverage and at best, they provide
partial protection against losses. In addition, they are often insufficiently detailed
in the contract and thus are difficult to interpret and implement.

Invoicing in the Organization’s National Currency

Foreign buyers are rarely willing to pay invoices in the seller’s native currency,
since doing so transfers the FX risk to them. If the foreign company is a poor
FX risk manager, this may increase its purchasing costs even if prices are not
raised. If an organization insists on being paid in its own currency, the foreign
company may also seek out new suppliers. Thus, billing in the organization’s
national currency presents no genuine advantages. In general, it is better for
organizations to avoid this approach and learn how to effectively identify,
measure and manage FX risk instead.

Raising the Export Selling Price

To use this strategy, the selling price is raised in the foreign currency to offset
a possible depreciation of this currency’s value. Adjusting prices this way is not
a true hedge against FX risk and cannot be used as a substitute for FX hedging
instruments. Some exporters have learned this the hard way in recent years due
to dramatic fluctuations in exchange rates.

If an organization can raise its prices to offset the potential depreciation of

a foreign currency, then it holds some pricing power. This pricing power is a

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Feasibility of International Trade

competitive advantage worth protecting against FX risk. In this context, consider

the example of BEDM Systems. The company is selling its product in the United
States for USD 95 per unit, based on a reference rate of USD/CAD 1.0525.
Imagine that BEDM finds that it has some pricing power and is able to raise its
export price to USD 100 per unit.

By hedging all its FX risk immediately after raising its price, BEDM ensures that it will
receive CAD 105.25 per unit sold (USD 100 x 1.0525), thus realizing a 36.8 percent
profit margin. Since the profit margin was 30 percent when the selling price was
USD 95 per unit, the additional 6.8 percent represents a 23 percent increase
in profit resulting from the new, higher price. An organization’s ability to raise
export prices is a valuable business advantage that should not be wasted by
neglecting the management of FX risk.

Formulating a FX Policy
Crafting an FX policy gives an organization the opportunity to proactively
define the key values that underpin any effective FX risk management program.
In defining the methods it will use to manage FX risk, an organization has
developed its FX policy. Given the FX policy can have on profitability and cash
flow, it is crucial that it is improved by both senior management and the Board
of Directors.

The details of BEDM’s hedging strategy, as summarized in Table 1.4, include the
following:

• It excludes the use of FX options and concentrates on FX forward contracts.

• FX risk is not fully covered. The selected hedging ratio is 80 percent, which
indicates that BEDM is willing to tolerate some FX risk. It also implies that
the company has measured the risk associated with partial hedging and
has found it acceptable.
• BEDM’s coverage uses a combination of systematic and progressive
hedging. Using progressive hedging, BEDM links the implementation of
50 percent of its FX coverage to future exchange rate fluctuations. This
means that BEDM hopes that these future fluctuations will be favourable
and will add to the company’s profits.
• The profit threshold exchange rate set by the company is USD/CAD 1.1200.
If the rate hits this level, the company will realize an FX gain of CAD 6.40
per unit sold when purchasing its FX forward contracts.

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 Analyzing and Mitigating Currency/Foreign Exchange Risk

• Conversely, there is a loss threshold of USD/CAD 1.00. If the rate reaches

this level, BEDM will suffer an FX loss of CAD 5.00 per unit sold when
it purchases FX coverage. The company established this threshold by
analyzing the financial consequences of a range of potential exchange
rate shifts.
• The decision to use a progressive hedging approach implies that BEDM
has the time and resources to follow FX markets closely and is disciplined
enough to put coverage in place as soon as the rate reaches either
threshold.

The following is the final FX policy for the example of BEDM.

Table 1.4 – BEDM’s FX Policy Statement

BEDM Systems Inc. – FX policy statements

Effective from January 1 to December 31, 2012
Reference rate USD/CAD 1.0525
(Parameter 1)
Time horizon 12 months
(Parameter 2)
FX position USD 12,515,000 as of January 1, 2012
(Parameter 3)
Hedging strategy The strategy includes the following:
(Parameter 4)
1 | Hedging instruments: FX forward contracts only
2 | Hedging ratio: 80% (sale of USD 10 million)
3 | Hedging approaches:
 Systematic hedging: 50%, immediate sale of
USD 5 million at the rate of USD/CAD 1.0525
 Progressive hedging: 50%, deferred sale of
USD 5 million at a loss threshold rate of USD/
CAD 1.0000, or a profit threshold rate of USD/
CAD 1.1200, whichever occurs first.

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Feasibility of International Trade

Implementing and Monitoring an FX Policy

To recap, the strategies used to manage FX risks are:

• Employing hedging instruments • Natural hedging

such as FX forward contracts
• Transferring of risk to the buyer
and FX options
• Raising the export selling price
• Invoicing in the organization’s
national currency

When an organization has defined which methods it will use to manage FX risk,
it has developed its FX policy. Once a policy has been determined, it must be
implemented by the organization. This includes communicating the policies to
all relevant stakeholders. These stakeholders may include specific employees,
managers and the Board of Directors, among others.

As depicted in Figure 1.1, no risk management cycle is complete without Step

9: Monitoring, Evaluating and Adjusting. Organizations must constantly assess
their FX policy and risk tolerance to determine if it is functioning effectively.
This constant monitoring helps to ensure that the organization will maintain its
profitability.

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SUMMARY

Today’s organizations operate in an environment that is constantly changing,

often in unpredictable ways, subjecting them to elevated levels of risk.
Organizations operating internationally face a wider range of risks, such as
exchange rate fluctuations and foreign government politics, which do not affect
organizations trading domestically. Every organization will have its own internal
level of risk tolerance and areas of concern related to international ventures, but
it is important to be aware of the most common risks facing all organizations
and understand how to develop appropriate risk mitigation strategies.

Generally, organizations use a risk management process, which takes them

through the steps of identifying risks, evaluating their likelihood and possible
impacts, developing and implementing mitigation strategies and monitoring
performance. There are different types of risks for organizations to consider
before engaging in international trade. To minimize negative impact on profit,
organizations must analyze and mitigate foreign exchange rate fluctuations.
This involves, recognizing currency/foreign exchange risks and then using the
risk management process to ensure these risks are mitigated.

Companies need to be able to review currency/foreign exchange risk data,

measure the sensitivity of profit margins to foreign exchange fluctuations, and
identifying the corresponding time horizon associated with transactions that
are exposed to risk. By calculating the organization’s overall risk exposure and
financial position, these risks can be managed using hedging strategies, financial
swaps and a number of other approaches. This process should also include the
establishment of a foreign exchange policy that can be implemented, monitored
and managed on an ongoing basis.

Analyzing and mitigating risk is critical to determining the feasibility of a new

venture. If new ventures meet the organization’s criteria for profit potential and
risk, it can be included in its international business plan and market entry plan,
and then implemented to achieve its business goals. The International Market
Entry Strategies course describes the planning and implementation processes
related to launching the new initiative.

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Feasibility of International Trade

The process of adapting to new trends and mitigating risks needs to happen
as quickly as the changes are occurring. In today’s global economy, everything
is faster—including processes, products, start-up speed, creation and
implementation of new ideas—than it has been in previous decades. Risk analysis
and mitigation must be monitored and adapted at a similar pace.

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Apply Your Learning

Apply your understanding of the knowledge and skills addressed in this Unit. The
answer key is provided on page 31.

1 | Describe two types of financial hedging instruments.

2 | What is natural hedging and what are its advantages and disadvantages?
3 | A U.S.-based company that exports auto parts to Europe notices that the
foreign exchange rate between the U.S. dollar and the Euro has tipped
into a range that is unfavourable. In the past, the company has neglected
to examine this FX risk but it now wants to analyze the FX risk and establish
an FX policy. What are the steps that the company needs to follow to
accomplish this goal?

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Feasibility of International Trade

Extended Learning
Challenge yourself to apply learning from this Unit in more complex situations
and contexts that relate to your own environment or ones of particular interest
to you. Answers will vary. No answer key is provided.

1 | Using your own organization, or a sample organization of your choosing,

calculate the organization’s FX position. Choose mitigation strategies
(such as financial hedging instruments, natural hedging, etc.) and justify
your choices. Document the analysis in a new FX policy.
2 | Develop and support an argument for why corporations will reduce overall
FX risk by going multinational.

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Apply Your Learning - Answers

Below are the answers to the questions presented on page 29.

1 | Describe two types of financial hedging instruments.

 Answer: Two types of financial hedging instruments are:
» FX forward contract: Pertains to an organization’s commitment
to exchange predetermined amounts of two different currencies
at a future date. The rate of the currencies is guaranteed by the
contract.
» FX option: Provides the option holder the right, but not the
obligation, to buy or sell a given amount of a foreign currency
on a specific future date. The exchange rate is guaranteed in the
option contract.

2 | What is natural hedging and what are its advantages and disadvantages?
 Answer: Natural hedging is when an organization pays its invoices and
collects its export revenue in the same currency. It is advantageous
when exchange rate fluctuations are unfavourable, but it also limits an
organization’s ability to profit from favourable rates.
3 | A U.S.-based company that exports auto parts to Europe notices that the
foreign exchange rate between the U.S. dollar and the Euro has tipped
into a range that is unfavourable. In the past, the company has neglected
to examine this FX risk but it now wants to analyze the FX risk and establish
an FX policy. What are the steps that the company needs to follow to
accomplish this goal?
 Answer: The steps the organization needs to follow to accomplish
this goal are:
1. Review currency/foreign exchange risk data.
2. Select the reference rate.
3. Measure the sensitivity of profit margins to FX fluctuations.
4. Identify the time horizon.
5. Calculate the organization’s FX position.

© FITT 31
Feasibility of International Trade

6. Identify and choose mitigating strategies, for example:

a. Hedging instruments
b. FX swaps
c. Natural hedging
d. Transferring risk
7. Determine the FX hedging ratio.
8. Formulate FX policy.
9. Implement and monitor FX policy.

32 © FITT
NOTES

1 The main source document for this unit, including all tables, is from
Building a Foreign Exchange Policy, Export Development Canada. Export
Development Canada, Building a Foreign Exchange Policy (Export
Development Canada, 2015), https://www.edc.ca/en/guide/building-
foreign-exchange-policy.html. Visit the Export Development Canada
website at www.edc.ca to learn more about export trade.

2 Eric Reed, “Transaction Exposure: International Investing,” Smart Asset,

November 2, 2022, https://smartasset.com/investing/transaction-
exposure.

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