Forex Risk Management Tips
As Currency fluctuations can adversely impact SMEs, it is very important for SMEs to protect their exposure in an efficient and effective manner. We feel that every SME should follow the following steps to manage their exposure:
Determine risk exposure : The following will help SME’s to determine their risk exposure:
- Percentage of sales or purchases (especially receivables and payables) that is done in foreign Currencies?
- Is the environment such that your SME is not in a position to pass on the Currency losses by increasing the prices?
- Can you enter into price variance clauses with your customer based on exchange rate fluctuations?
- Do you have a tight cash flow? Can adverse Currency fluctuation cause problems for you?
- At what point will a change in exchange rates affect your profitability significantly?
- Which Currencies are you exposed to and in which Currencies do you have payment obligations?
Determine risk mitigation strategy : The following strategies may be followed, depending on the level of risk exposure:
A. Selective hedging : This is a good method if you have significant but short-term foreign Currency exposure. In such a scenario, you can decide to hedge 50% to 60% of your total exposure and accept the benefit or loss from the unhedged portion.
B. Systematic hedging : Here, you hedge your position as soon as you enter into any foreign Currency commitment. As a general rule, the more your business relies on Forex cash flows, the more you should hedge against foreign Currency risk.
C. No hedging : In this situation you simply accept the Forex risk. Hedging is not necessary if only an insignificant part of your total business is exposed to Forex risk or if you can pass on the entire benefit or loss arising from foreign Currency transactions to the customers.
B. Systematic hedging : Here, you hedge your position as soon as you enter into any foreign Currency commitment. As a general rule, the more your business relies on Forex cash flows, the more you should hedge against foreign Currency risk.
C. No hedging : In this situation you simply accept the Forex risk. Hedging is not necessary if only an insignificant part of your total business is exposed to Forex risk or if you can pass on the entire benefit or loss arising from foreign Currency transactions to the customers.
Determine risk mitigation tools : You may want to choose from any of the following tools:
A. Currency diversification: You can reduce your Currency risk by diversifying the Currency base. For example, you can reduce your dependence on USD/INR exchange rates by accepting orders in other Currencies such as Euro, Yen, etc.
B. Forward contracts: The Forex Forward contract is an agreement to convert a given amount of a Currency into another at a predetermined exchange rate and on a predetermined date. It is the preferred instrument for hedging against Forex risks.
C. Swaps: A swap involves simultaneous Spot and period transactions of one Currency for another. It is used when you have receivables and payables in the same Currency with due dates that do not match. D. Call and Put Options: Call and Put Options act like an insurance policy. They allow you to profit when exchange rates shift in your favour and also protect you when the opposite happens.
B. Forward contracts: The Forex Forward contract is an agreement to convert a given amount of a Currency into another at a predetermined exchange rate and on a predetermined date. It is the preferred instrument for hedging against Forex risks.
C. Swaps: A swap involves simultaneous Spot and period transactions of one Currency for another. It is used when you have receivables and payables in the same Currency with due dates that do not match. D. Call and Put Options: Call and Put Options act like an insurance policy. They allow you to profit when exchange rates shift in your favour and also protect you when the opposite happens.
