Planning to set up an international business and worried about the various risks involved in it? Before indulging in to such a venture, you must take a lesson from some experts in this field, and stay updated to the latest news in international businesses. Keeping an eye on how do international businesses seek to minimize foreign exchange risks, you can minimize the level of risk involved in your business.
What is Foreign Exchange risk and why you need to manage foreign exchange risk?
In international businesses, two or more countries are involved. When a transaction takes place it is in different currencies, and here comes the risk of foreign exchange. Foreign exchange risk is the possibility of change in the rates of currency. A fall or rise in rates will hamper either of the party in the transaction.
There are three types of foreign exchange risks:
- Transaction exposure:
For example, if $1 was equal to Rs.45 and later it increases to Rs.50, then the paying party will have to pay more.
- Accounting Exposure:
This occurs when assets and liabilities are converted from one currency form to another.
This will result in gain and losses in foreign exchange of the company.
- Economic Exposure:
The overall influence of change in exchange rates on a company is known as Economic Exposure.
Why to manage or hedge foreign exchange risk?
Some companies find this task as a time consuming, complex activity. They do not wish to hedge this risk, assuming that the exchange rates will remain the same. However, hedging or managing foreign exchange risks will benefit you as following:
- Reduce the impact of the fluctuating exchange rates on the company’s profit margin
- Right Estimation of incoming and outgoing cash flows
- Elimination of forecasting exchange rates
- Help in pricing the products
How to manage foreign exchange risk?
If you are wondering, how do international businesses seek to minimize foreign exchange, reading the tips and instruments given below will help you answer this question.
Four simple steps to minimize foreign exchange risk:
Identify Foreign Exchange Exposure for your firm
Develop a Foreign Exchange Policy for your firm
Use Instruments and Techniques for managing foreign exposure
Analyze and Adjust Policies from time to time
1. Identify Foreign Exchange Exposure for your firm
If your firm is paid in US dollars, you need to find out the difference between the amount you need to pay in US dollars, and the amount you will receive in US dollars in the same period. This difference will be the foreign exposure you need to hedge. If you have foreign currency balance in your bank, then subtract the same from the difference you calculated to find out the net exposure that is to be hedged.
2. Develop a Foreign Exchange Policy for your firm
The management of the company should develop a policy with the help of financial experts. The company should take into account all the transactions and possibilities and formulate a policy accordingly.
3. Use Instruments and Techniques for managing foreign exposure
- Deliverable FX Contract:
This is a contract that will help you book the requirement of your currency in advance. The tenure of the contract is around 6 months. This will save you from the shift in foreign exchange rates.
- Non Deliverable FX contract:
You can opt for an NDF contract when the rules and regulation in the country you are transacting with, limits the transaction to domestic companies only.
- Currency Option:
This helps you to buy or sell currency in future. This will help you benefit when the rates are in your favor.
4. Analyze and Adjust Policies from time to time
Periodically examine the policies and alter it as per the requirements of your company and the currency regulations and fluctuations. This will help you stay prepared for any currency fluctuation.
Besides these, there are some other instruments and techniques that will help you to hedge the foreign exchange risk
- Natural Hedging:
In Natural Hedging, a company tries to reduce the transaction exposure. For example, if a company based in Singapore has to receive US$5 million, and has to pay them US$400,000 then the exposure for the Singapore company is 4.6million US dollars.
The company will thus try to reduce it by borrowing 1 million US dollars; procuring raw material valued 1.5 million US dollars. Thus, now the transaction exposure for the Singapore Company will only be 2.1 million US dollars.
- Forward Contracts:
This helps a company to enter in to an agreement in advance to decide the exchange rate at which the transaction will take place at a fixed time and date. This will again eliminate the transaction exposure for your company. If the exchange rates rise, you won’t get extra benefit but if it falls, you will not suffer any losses.
These are some ways that international businesses seek to minimize foreign exchange risk. Opt for minimizing foreign exchange risks for your business and choose a way, which is the best for your firm.