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Forex Trading And Risk Assessment: Legal Aspects In Las Vegas – This useful guide by financial expert Paul Ainsworth draws on over 30 years of experience as CFO of large multinational companies to develop a menu of options companies face to deal with foreign exchange risk and manage it effectively.
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Forex Trading And Risk Assessment: Legal Aspects In Las Vegas
Exchange rate fluctuations are commonplace. From a vacationer planning a trip abroad and wondering when and how to get local currency, to a multinational organization buying and selling in multiple countries, the consequences of making a mistake can be significant. This is why foreign exchange risk management (or forex risk management) is so important.
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During my first overseas assignment in the late 1990s and early 2000s, I came to work in Hungary, a country undergoing massive change after the regime change in 1989, but a country where foreign investors wanted to invest. The transition to a market economy created significant currency volatility, as shown in the chart below. The Hungarian Forint (HUF) lost 50% of its value against the USD between 1998 and 2001 and then regained all of it by the end of 2004 (with significant fluctuations).
Since foreign exchange trading with HUF was in its infancy and therefore hedging was prohibitively expensive, it was during this time that I learned how foreign exchange fluctuations can affect the P&L. In the reporting currency USD, results could go from profit to loss based solely on changes in exchange rates, and this introduced me to the importance of understanding foreign exchange and currency risk management.
The lessons learned have proven invaluable throughout my 30+ year career as a CFO of large, multinational companies. However, I still see many cases where companies fail to adequately mitigate foreign exchange risk and suffer the consequences. For this reason, I thought it would be useful to create a simple guide for those who want to learn about ways to avoid currency risk, as well as the opportunities that companies face by sharing their personal experiences. I hope it will be useful.
This is the simplest form of foreign exchange exposure and, as the name suggests, arises from an actual business transaction that takes place in a foreign currency. The risk arises, for example, due to the time difference between the right to receive cash from the customer and the actual physical receipt of the cash or, in the case of payment, the time difference between the creation of the purchase order and the payment of the invoice. .
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Example: A US company wants to buy equipment and after receiving offers from several suppliers (both domestic and foreign) has chosen to buy Euros from a company in Germany. The machine costs €100,000 and the €/$ exchange rate at the time of the order is 1.1, which means the company costs $110,000 in USD. Three months later, when the bill is due, the $ has weakened and the €/$ exchange rate is now 1.2. The cost to the company to pay for the same €100,000 is now $120,000. The exposure to the transaction has resulted in an additional $10,000 in unanticipated costs to the company and may mean that the company could have purchased the equipment at a lower price. from one of the alternative suppliers.
Sometimes known as exchange rate risk, it is the recalculation or conversion of a foreign subsidiary’s financial statements (such as the profit and loss or balance sheet) from the local currency to the reporting currency of the parent company. This arises because the parent company has reporting obligations to shareholders and regulators that require it to provide a consolidated set of statements in its reporting currency for all its subsidiaries.
Continuing with the above example, let’s say a US company decides to set up a subsidiary in Germany to manufacture equipment. The subsidiary will provide its financial data in euros, and the US parent company will translate these statements into USD.
The example below shows the financial performance of a subsidiary in the local currency, Euro. From the first to the second year, it has increased revenue by 10% and achieved some productivity to keep cost growth to just 6%. This results in an impressive 25% increase in net income.
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However, due to the impact of exchange rate changes in the parent company’s reporting currency, USD, the financials look very different. Over the two years in this example, the dollar has strengthened and the EUR/$ exchange rate has fallen from an average of 1.2 in year 1 to 1.05 in year 2. Financial performance in the USD looks much worse. Revenue is reported to be down 4% and net income, while still showing growth, is only up 9% instead of 25%.
Of course, the opposite effect can occur, which is why when reporting financial results you’ll often hear companies quoting both a ‘statement’ and a ‘local currency’ number for some key figures, such as revenue.
This latter type of foreign currency exposure is caused by the impact of unexpected and unavoidable currency fluctuations on the company’s future cash flows and market value and is long-term in nature. This type of exposure can affect long-term strategic decisions such as where to invest in manufacturing capacity.
In my Hungarian experience, which I referred to at the beginning, the company I worked for moved a lot of capacity from the US to Hungary in the early 2000s to take advantage of lower production costs. It was more economical to manufacture in Hungary and then ship the product back to the US. However, the Hungarian forint then strengthened significantly over the next decade and wiped out many of the expected cost gains. Exchange rate changes can significantly affect the competitiveness of a company, even if it does not operate or sell abroad. For example, a US furniture manufacturer that sells only domestically still has to contend with imports from Asia and Europe, which may become cheaper and therefore more competitive if the dollar strengthens significantly.
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The first question to ask is whether there is any concern at all in trying to mitigate the risk. It may be that the company accepts the risk of currency fluctuations as a cost of doing business and is prepared to deal with potential profit fluctuations. A company may have a high enough profit margin that provides a buffer against exchange rate fluctuations, or it may have such a strong brand/competitive position that it can raise prices to compensate for adverse changes. In addition, a company can trade with a country whose currency is pegged to the USD, although the list of countries with a formal peg is small and not as significant in terms of trade volume (except Saudi Arabia, which has had a peg since 2003).
For those companies that choose to proactively manage currency risk, the tools available range from very simple and low-cost to more complex and expensive.
Companies in a strong competitive position, selling a product or service with a superior brand name, can transact in only one currency. For example, a US company may require invoicing and payment in USD even when operating overseas. Thus, the exchange risk is transferred to the local customer/supplier.
This can be difficult in practice due to certain costs that must be paid in the local currency, such as taxes and wages, but it can be possible for a company whose business is primarily online.
What Are The Major Types Of Foreign Exchange Risks?
Many companies that operate large infrastructure projects, such as those in the oil and gas, energy or mining industries, are often subject to long-term contracts that may include a significant foreign exchange element. These contracts can last for many years, and exchange rates at the time of contract and pricing can fluctuate and threaten profitability. It may be possible to include foreign exchange clauses in the contract that allow for revenue recovery in the event that exchange rates deviate by more than an agreed amount. Any foreign currency risk is thus transferred to the customer/supplier and will need to be negotiated in the same way as any other contractual clause.
In my experience, this can be a very effective way to hedge against foreign currency fluctuations, but requires strong legal language in the contract and very clear indices against which exchange rates are measured. These clauses also require regular reviews by the finance and trading teams to ensure that the necessary process for indemnification is in place after the exchange rate clause is triggered.
Finally, these clauses can lead to tough commercial discussions with customers if triggered, and I have often seen companies choose not to apply to protect customer relationships, especially when the timing coincides with
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