If you and your business are feeling the pressure of recent political or economic events then you may need to change or improve your approach to FX risk management . Here are the most common mistakes made by companies with their FX risk management and how you can avoid them.
Taking a view or guessing where the currency market is not going to be an effective risk management strategy.
If you want your approach to managing FX exposure to be successful then it shouldn’t be influenced by a directional view or by the most recent trends that have occurred.
Instead you should hedge your exposures in a manner that suits your business objectives. For example, setting budget rates and hedge ratios is a good place to start, our article “A Quick Guide to Budget Rates and Hedge Ratios”, covers the basics.
Outside of guessing where rates are going, one of the biggest causes of FX loss in business today is trading with emotion. The whole point of setting up budget rates, hedge ratios and defining a strategy for the next financial year is to protect the risk of financial loss for your business.
What we often see happening though is a business moves outside of their well defined plan or doesn’t really have a plan at all.
In this situation, a business will set up hedges but will begin to think they are losing out when the market improves compared to their hedged position. Then they typically decide to terminate the hedge so that they can purchase along with the rising market, but guess what happens next?
That’s right, the market falls and any position they had to protect them from downside now doesn’t exist. Worse yet, in a blind panic fearing further downside they rush to secure a hedge at a low rate and the market rises. Compounding their loses and creating a whole load of stress in the process.
Trading with emotion, without a systemised process, is a sure-fire way to making a loss for your business.
The best way to manage such a situation is not have to manage it at all. Take the time and forecast your exposure, define your hedging policy, stick to it and refine it as the market moves. Our article “A Quick Guide to Budget Rates and Hedge Ratios”, covers the basics.
Trading with emotion is a strategy where you can find yourself in a tight spot as it can lead to trading in a blind panic as you try to recoup your losses.
But equally, in some situations it is sensible to lock in your losses.
For example, if you’ve just learnt of a new exposure after you’ve set up your budget rate for the month but the currency has moved out of your favour compared to your budget rate, resulting in the corresponding hedge locking in a loss.
Typically, in this situation, no corresponding trade is made and excuses are made about inaccurate forecasts or some take a “we will wait and see” approach to avoid locking in a loss.
What you should do though is hedge out any exposure you have over a certain threshold. This can be hard to execute when you have a trade pending and the market is moving against you, but ideally such a decision should be made with the aid of a defined FX policy that is set up with your business objectives in mind.
In this situation, your FX policy should say: when a certain exposure is identified and it is beyond a minimum threshold it is hedged. Period.
When trading FX, hope is not a strategy. If you have an exposure you should have a process or policy set up with your business objectives in mind so that you are purchasing systematically and with your business goals at the forefront of your decision making.
A fear of change can be a major obstacle to FX management success.
Often, the stakes are high for businesses when it comes to FX management so the safety of maintaining current practices can be an easy solution to a complex problem.
Unfortunately, operating in this manner can open you up to to substantial risk as your business and the FX market are always changing. Any assumptions made years ago may not necessarily be an accurate representation of current trading conditions.
For a change to be considered typically a business will suffer a substantial FX loss before anyone considers the effectiveness of current practices.
The best approach is to proactively manage your exposures, learn from any issues you might experience and also seek the advice of qualified experts.
For businesses the knock on effect of exchange rate volatility may slow down sales, it could increase the prices of the products they supply, or relationships might break down with suppliers as pricing disputes fracture relationships and commercial agreements.
While many companies are keenly aware of the pain they feel when exchange rates move against them, if you find that you are frequently changing your pricing or the price you pay for your products is wildly volatile then it makes sense for you to ask yourself the following questions:
These questions should lead you down a path to consider how much or for how long you should hedge, whether to layer in hedge rates, and whether to purchase spot, forward contracts or options.
You may also need multiple strategies for different product lines or businesses.
A good way to test if a hedging strategy makes sense is to “stress test” with different “What if?” scenarios, which should include some modeling on how you and your competition suppliers and/or partners would react.
If your experience of a significant currency move in either direction is traumatic then it is probably time to start adjusting your hedging strategy.
As well as being conscious of how you trade FX, it is also important to be mindful of the practices of your FX partners.
Unfortunately, FX trading is plagued with businesses being charged too much for currency. As a result, it is extremely important that you understand how the market works, and also know where the market is when you are executing trades.
Resolving this issue can come in two forms: you can work with a reputable and trustworthy currency supplier who charges you in a fair and transparent manner, or at the very least when trading don’t assume you are getting a good price without having live data in front of you.
While many mistakes can happen as a result of your actions when trading FX, the recording and analysis of your activity can also lead to problems. For example, if your level of FX exposures and the relationships between them are fairly complex, using a spreadsheet to aid FX risk management can lead to a whole host of problems.
Currency, time, transaction relationships and exposure can quickly go beyond the two dimensional capability of spreadsheets. Links to multiple tabs or other spreadsheets can be extremely fragile and error prone. You only have to copy the wrong data, or miscalculate one exposure, let alone manage the working version of the spreadsheet across a team.
Also, depending on who is responsible for your FX risk management, your spreadsheet might morph into a monster that can only be navigated by the person who created it. Which might be good for their job security but it isn’t a good ongoing risk management solution for your company.
Your solution would be to work with an FX partner that has the capabilities to provide you with the reporting you need to make informed decisions in a simple and easy to use format.
In this article, we’ve summarised the 7 major mistakes that businesses are making while managing their FX risk and provided some basic solutions to the problems, if however your problems are more complex or you would like to find out more about how you can solve any one of the above problems then please get in touch with us using the form below.
In this article, we’ve summarised the 7 major mistakes that businesses are making while managing their FX risk and provided some basic solutions to the problems, if however, your problems are more complex or you would like to find out more about how you can solve any one of the above problems call me on +44 (0)330 380 30 30 or email greg@hawkfx.com.
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