There are three kinds of FX exposure: transaction, economic and translation that need to be managed:
- Transaction exposure arises when a company has a future receivables or payables that is denominated in a currency other than its home or functional currency because the ultimate value of these payments may be different due to possible changes in FX rates. There are two types of transaction exposure - explicit and implicit. Explicit transaction exposure begins when a receivable or payable is entered on the balance sheet and remains until cash is received or paid. Implicit transaction exposure begins when the goods/services price list is made available to customers, and it is not possible to change these prices when FX rates change. This form of transaction exposure remains explicit until the order is booked. This is the most common type of exposure and is hedged through the use of currency derivatives.
- Economic exposure is the long term risks faced by a company that has business or holds investments abroad. It can include changes in FX rates or the chance of countries defaulting on their debt. Even companies that only operate domestically are susceptible to economic exposure whenever there is foreign competition within their local market whose operations are based in another currency.
- Translation exposure arises when a foreign subsidiary's financial statements are converted into a parent company's home currency as part of consolidating a company's financial statements. Using financial instruments to hedge this type of risk are not cost-effective due to the large amounts involved.
Most companies use a range of internal techniques and processes first to minimise FX exposure and then, depending on their FX policy, hedge the remaining FX exposures using three types of FX instruments:
- Forward exchange contracts in which the exchange rate is agreed together with the payment amount, vale date and settlement procedure, so allowing the importer or exporter to fix, at the time of the contract, the price for the purchase or sale of a fixed amount of foreign currency
- Currency futures which are exchange-traded financial contracts from exchanges such as the Chicago Mercantile Exchange which provides the advantage of future contracts that the prices are published and are completely transparent, so removing the need to shop around for the best price
- Currency options which entitle the company purchasing the option to buy (in call options) or sell (in put options) foreign currency at an agreed rate (called the strike price) during the term of the option up to the maturity/expiry date. There are two types of option with the right to sell or buy: either being valid for a pre-arranged term (an American option) or only at the expiry date (an European option).
Choosing the most cost-effective combination of these instruments is a complex decision. The solutions vary greatly between companies depending upon their trade flows, legal and operating structures, and risk appetite. There are many advisors and consultants, brokers and banks which provide advice and support on the FX options and strategies. The FX hedge and risk management systems and services to minimise FX exposures, and correctly report and account for any FX hedges vary greatly. An important difference between the providers is the quality of the work they carryout to understand and accurately describe the exposures before they input the data into their analysis systems, as always: Garbage In will produce Garbage Out, regardless of how good the system is.