• Matheus Zani

Expanding your business overseas? How will FX risk affect you?

Updated: Nov 24, 2020

How can a hedging strategy allow a firm to enter new markets with confidence, expand its global operations and scale safely with more comfort and clarity?

Along with the excitement and anticipation of venturing out of a company's local market, comes hurdles that must be overcome to have a chance at success.

Foreign Exchange (FX) risk is one of these hurdles, and some would argue the biggest. When businesses are expanded into international markets, the number of currencies in their operations also tends to increase, thus exposing their new venture to FX risk.

But, how much can a currency exchange rate change?

In short, A LOT.

For instance, Brazilian Real has weakened 40% against the dollar since the beginning of 2020, making it the worst-performing currency in the world, not a sought after the title! This is not a lone example, the South African Rand also saw its value decrease by 21%. More?

The seasonal data shows that the major emerging market currencies have declined against the dollar in the past 8 months. However, some currencies have gained back some of their losses as investors look to wind the carry trade back up and reinvest in emerging economies, despite the continuing fear surrounding the global crisis sparked by Covid-19.

Now, you might be wondering if Covid-19 is solely responsible for the recent currency fluctuations.

The answer is a resounding no.

2020 has clearly not been an easy year for many countries, yet, many of these difficulties pre-date coronavirus. For example, Latin American countries were already immersed in political and social turbulence. Civil disturbances and domestic political crises had broken out across Brazil, Chile, Ecuador, Bolivia and among others.

In advanced economies, many of the protests had begun for similar reasons, such as a deep frustration with political establishments that had failed to address recurrent economic insecurity at the household level. Also, a million people had joined a global climate strike to protest against deforestation and pollution.

When the crisis, sparked by Covid-19 arrived in the occident, many countries were immersed in chaos and struggling to address their own domestic conflicts. As the death tolls increased, new restrictions were put in place, causing a slowdown in global economic activity and currency depreciation in weak economies.

Therefore, against this background, such volatile currency movements are not about to lessen in the short term.

Why should all international firms be aware of the risk of these foreign exchange movements?

Foreign exchange fluctuations affect numerous business transactions including:

  • Export receivables

  • Import payments

  • Intercompany payments between offices and subsidiaries

  • Foreign currency loans

  • Other income (royalties, interest, dividends, etc.)

Moreover, foreign exchange rate fluctuations affect many aspects of international business, such as cash flow, settlement of contracts and the firm’s valuation.

For a specific sector example, the flowchart below provides a high-level examination of the fruit exportation industry. If the exporter has invoiced in the buyer’s currency or any other currency different from its functional currency (generally U.S dollar), they will be exposing their profit margins to currency fluctuations.

As an exporter, FX risk frequently occurs because of their need to convert the invoice into the buyer’s currency (or U.S Dollar) at the prevailing spot rate on the day that the invoice is issued. His client (buyer) then settles the invoice in their local currency, typically anywhere between 15 to 60 days later, depending on the terms that they have demanded. Then, only after the funds have been received, can the exporter convert the payment into their local currency.

This leaves the fruit exporter exposed to changes in the local currency during the time lag or lead time between an invoice being issued and payment being received. Put simply, if the Brazilian exporter is required to invoice a customer in U.S Dollar and the BRL appreciates against the U.S Dollar during this period, the exporter will receive less BRL than originally anticipated. See below an example:

1) Without FX hedging strategy

On 24/08/20 - Deal Agreement

  • Value Invoice due to 30/11/20 = USD 350,000

  • USDBRL spot rate on 24/08/20 = R$ 5.60

  • Expected BRL Notional to receive = 350,000 x 5.60 = BRL 1,960,000

On 30/11/20 - Converting Invoice

  • The brazilian fruit exporter converts the receivables from USD to BRL using spot rate on 30/11/20 = R$ 5.34

  • BRL Receivable = 350.000 x 5.34 = BRL 1,869,000

In this period from 24/08 to 30/11, the BRL appreciated against the U.S Dollar, the exporter received BRL 91,000 less than initially expected.

It is therefore important that these export firms understand the potential impact of FX risk to their bottom line and how to best manage it. Especially in a year such as this.

Foreign exchange risk management strategies

With hedging strategies in place, not only can companies protect receivables or payments against market volatility, but also maximize its profit by taking advantage of the structure and movements of the FX market.

There are four basic types of derivatives: forward, futures, options and swaps. A derivative contract is a contract between two parties which specifies that an amount of cash may be exchanged at a later date at a price fixed today. The value of the contract is derived from the current spot rate and a forward rate which takes into consideration the interest rate differential between the two counterparty’s countries.

Type 1: Forward Contracts

A non-deliverable forward (NDF) is an agreement between two parties to buy or sell an agreed amount (of the non-convertible currency), on a specific due date, and at a defined forward rate. At maturity, the forward rate is compared against the reference rate of that day. The difference between the pre-agreed forward rate and the fixing rate is settled in the convertible currency on your account at the due date. Therefore, you will either pay or receive the difference. As with a forward transaction, the costs of an NDF corresponds to the interest differential between the two currencies.

Type 2: Futures Contracts

Similar to an NDF contract, the futures contract is an agreement between two parties to buy or sell an agreed amount (of the non-convertible currency), on a specific due date, and at a defined forward rate. However, a futures contract is traded on organized futures exchanges and obliges its purchaser (seller) to buy (sell) a given amount of cash (lot size) at some stated time in the future. The counterparty risk is low as they are exchange-traded however rigid contract sizes and daily margin requirements can make them hard to manage.

Type 3: Option Contracts

An option on a futures contract is the right, but not the obligation, to buy or sell a particular futures contract at a specific price on or before a certain expiration date. There are two types of options: call options and put options.

Type 4: Swaps

A swap is an agreement between two counterparties to exchange financial instruments, cash flows or payments at a certain time.

If we go back to the example above, where the fruit exporter has a receivable of USD350,000 and we implement an FX hedging strategy using a forward contract, we will have the following result.

2) With FX hedging strategy

On 24/08/20 - Deal Agreement

  • Value Invoice due to 30/11/20 = USD 350,000

  • USDBRL spot rate on 24/08/20 = R$ 5.60

  • USDBRL forward rate for 30/11/20 = R$ 5.70

  • Notional BRL hedged = 350,000 x 5.70 = BRL 1,995,000

On 30/11/20 - Converting Invoice and Hedge expiration

  • The brazilian fruit exporter converts the receivables from USD to BRL using spot/PTAX rate on 30/11/20 = R$ 5.34

  • BRL Receivable = 350.000 x 5.34 = BRL 1,869,000

  • The hedge strategy (NDF) expires against the spot/PTAX rate on 30/11/20 = 5.34

  • FX Hedging strategy result = 5.70 – 5.34 = R$0.36

  • 350.000 x 0.36 = + BRL 126,000

The total result is:

  • BRL Receivable due to exportation = R$ 1,869,000 (a)

  • Hedge Result = + R$ 126,000 (b)

  • Total (a+b) = R$ 1,995,000

If we compare both cases (with and without FX hedging strategy), we can see that the exporter not only protects the spot rate at R$ 5.60, but also he maximizes his profit due to the forward curve that allows him pricing his invoice using a forward USDBRL rate at R$ 5.70.

Thus, the exporter receives BRL 126,000 more than without an FX hedging strategy in place.

Hedging – The Advantages

Hedging offers definite advantages to international firms and costs comparatively little. Hedging with the derivatives mentioned above allows an organization to lock in a foreign exchange rate that stabilizes a company’s operating costs or sales revenue whilst protecting their budget rate. Setting and protecting a budget rate can allow a firm to enter new markets with confidence, expand its global operations and scale safely with more comfort and clarity.

It is important that the FX risk is managed, so the C-suite can focus their energies on core business operations, and not currency fluctuations.

An FX specialist can help put together a risk management strategy that is bespoke to a client’s requirements. A great consultant will help you understand the strategy and give you all that you need to get buy-in from your stakeholders and swiftly implement it.

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