When implementing an FX Risk Management strategy, an important realization for any business, is that forecasting and managing directional moves in exchange rates can be one of the greatest business uncertainties of dealing in international trade.
When making FX hedging decisions there is without doubt some internal and operational decision making processes that produce more optimal outcomes than others. In this post I will highlight the most common traits of businesses, when managing risk in the foreign exchange market. I believe it’s important to recognize weaknesses. Only then are we are able to learn and find room for improvement.
Behavioral factors often dictate decision making more than true business fundamentals. Market noise and irrelevant financial information often develop into a ‘market view’ for a decision maker. Risk management decisions commonly get caught up in continuous market volatility ignoring more important internal metrics.
No FX Policy
No consistent and in depth plan to follow. Many businesses will create an in-depth plan for a new product launch and international expansion, but forget about a plan to manage exchange rate movements. FX risk management decisions often lack consistent reasoning or justification; many can be influenced by complete randomness. Implementing a strategic and structured approach, with distinct guidelines, leaves far less room for errors.
Lack Of Forecasting
Increased costs and missed opportunities due to no planning of a transactional time-line. Analysis of future cash flows can provide immense value in times of market volatility. FX hedging decisions require forward thinking (often months to years in advance). The more planning and forecasting that goes into business cash flows the greater chance of taking market opportunities when they present themselves.
There are many important variables to consider when evaluating the performance of a hedging program or strategy. A few examples include; competitors pricing, internal risk appetite and internal pricing dynamics. Commonly an exchange rate is seen as the only benchmark when analyzing the success or failure of an FX hedging strategy. Understanding that an FX risk management strategy is much more that ‘beating the market’ will lead to more sound decision making.
Important FX risk management decisions can often be left to one person or small group. Human nature dictates that greater confidence is built through recent successes, for example: in hedging decisions or exchange rate forecasting. This has a tendency to increase an individual’s risk appetite. Future decisions can them become based on the assumption of intellectual superiority and ‘markets know how’ rather than for valid business reasons.
Flexibility In FX Strategy
Being flexible in FX risk management decision making enables a business to be prepared for any market irregularities. These can be either positive or negative, depending if you are an importer or exporter in a particular market. Significant directional moves in currency markets occur far more frequently than theory would suggest. These are easy to analyze in hindsight but managing in real time takes in-depth planning and preparation
Risk Appetite and Awareness
Due to varying FX exposures and transactional types, identifying exactly when exposed to exchange rate risk is extremely important. Time horizons can vary from deal to deal, within different cash flow cycles and also when utilizing various funding mechanisms from finance organizations.
Establishing an organizations FX risk appetite gives a clear indication of what decisions can or cannot be made in various different market environments. Often this judgment can become clouded during time of market volatility.