The problem of how to best manage foreign exchange volatility has plagued multinational companies for decades. In a 2022 survey by Deloitte, FX volatility ranked among the top treasury challenges facing organizations—with the lack of visibility of FX exposures and reliability of forecasts an issue for 83% of respondents.
Rapidly changing business models make life especially difficult for those managing foreign exchange risk, and many pitfalls await the ill-prepared.
What follows is a list of five of the most common—and costly—mistakes multinational companies make when managing their FX risk and the solutions for gaining more control and visibility.
5 common mistakes + how to solve them
Mistake 1: Taking a view on the direction of currencies
Do you or your business partners take views on currencies to determine your revenue or expense hedging strategies? Chances are that if you ask five different banks where they think a currency rate will be in a year, you’ll get five different forecasts, and the average will be fairly close to the current spot rate. If there happens to be widespread agreement by the banks on their directional views, this actually has a better chance of being a contrary indicator than an accurate forecast.
Solution
A successful hedging program shouldn’t be influenced by directional views or the most recent trends. Too often, a hedging program is terminated because it’s “losing money” just before the underlying exposure begins to lose value, and the hedges (now non-existent) would have had offsetting gains.
The success of a hedging program needs to take both the underlying exposure and the hedge into consideration when determining its effectiveness. Trying to guess what would happen on only one side of the equation is ineffective risk management.
Mistake 2: Not engaging enough with business partners
If you hedge your company’s local currency revenue exposure, do you understand the competitive environment in the various geographies where you do business and the corresponding pricing dynamics? Do you have any pricing power if there is a considerable move in FX rates?
Whether your primary exposures are revenue- or expense-related, several factors would influence how much and for how long you should hedge, whether to use options or forwards, whether to layer in hedge rates, how to interact with sales/procurement in terms of quoting/purchasing in local currency, and other considerations. A company may also need multiple strategies for various product lines or businesses.
Solution
An excellent way to test if a hedging strategy makes sense is to do a stress test with different “what if?” scenarios, which should include modeling how you and your competitors, suppliers, and partners would react. If you can’t live with the results of a significant currency shock in either direction, your hedging strategy needs some adjusting.
Mistake 3: Being afraid to lock in losses
This problem often occurs with balance sheet hedging. Let’s say you receive new information
on an exposure a week after you set your monthly accounting rate. The nature of this information is such that you should enter into an outright forward to adjust your hedge. However, the adjustment hedge will lock in a loss if the currency has moved out of your favor compared to the accounting rate. Too often in this scenario, no adjustment is made, and an excuse such as “our forecasts are never accurate” is used to avoid locking in the loss.
Solution
Your FX policy should take the emotion out of risk management (e.g., if the exposure as identified by a certain process is beyond a minimum threshold, it is hedged—period). Volatility is a function of time, so a week’s worth of unfavorable volatility can turn into a month’s worth of far more unfavorable volatility. “Hope” is not a strategy. If an exposure is material, hedge it.
Mistake 4: Creating unnecessary volatility from liquidity management
Failing to effectively implement a robust strategy for forecasting and hedging the balance sheet can expose companies to unwarranted FX volatility. This often occurs when companies overlook the importance of managing their liquidity needs in a timely and strategic manner.
For instance, consider a scenario involving a USD functional sales entity with EUR exposures (accounts receivable and cash) on the balance sheet, where a month-end accounting rate is used for the following month’s activity. When AR is collected, the transformation of EUR accounts receivable into EUR cash, both categorized as net monetary assets (NMA), has no FX impact on the balance sheet. However, a potential pitfall arises when a company aims to convert surplus EUR cash into USD, consequently affecting the EUR NMA.
Solution
Optimally forecasting and hedging the balance sheet can help avoid unnecessary volatility from spot or forward trading during the month when managing a company’s liquidity needs.
If a company wanted to convert any excess EUR cash to USD (which WILL affect the EUR NMA), an ideal balance sheet hedging process would result in an equal and offsetting adjustment to the outstanding balance sheet hedges. This utilizes an even FX swap instead of only a spot trade or an outright forward.
Whether this activity occurs on a company’s “netting day” or any other time during the month, using even swaps to manage liquidity needs avoids unnecessary spot rate versus accounting rate impact and eliminates the need to guess on collections or payables timing.
Mistake 5: Paying too much when trading FX
FX trading is incredibly profitable for banks, and in many cases, they are being compensated well beyond what is necessary for the risk they are taking. Banks are trying to maximize profit, so the person on the other side of the trade must understand the market dynamics.
Solution
At a minimum, someone on the corporate side executing FX trades should always know where the market is when trading. Don’t assume you’re getting a reasonable price without live data in front of you. Trading off of “fixing rates” is the best way to get the most transparency from the banks.
If it’s not practical to wait until the next fixing rate to trade, bid out the trade to multiple counterparties to get two-way prices. Even a two-way price will likely be skewed based on the side the bank might strongly suspect you’ll be looking for, and numerous trading solutions allow for anonymous trading.
Lastly, make sure you’re not trading externally more than necessary. While most companies net their exposures by currency, they often don’t take an additional step that can increase efficiency: triangulating exposures and utilizing “internal trades” between different hedging portfolios or entities where possible.
Protect your company with proper FX risk management
Trying to mitigate FX risk without sound policies, procedures, tools, and understanding of the market dynamics is risky. While the above is not a complete list of all the challenges FX departments face today, a company that can avoid these core problems would go a long way in creating a world-class FX organization.
You could solve these challenges internally, but it would take a lot of time and resources—both of which can be hard to come by.
AtlasFX can help. AtlasFX is the only complete SaaS FX risk management solution that optimizes the workflow. Built by corporate practitioners, AtlasFX has an unmatched depth of FX risk management and ERP experience and knowledge among competitors.
With AtlasFX, you can:
- Capture and manage FX exposures
- Improve forecasting
- Automate workflows
- Optimize trades
- Identity sources of FX variance and volatility
