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Foreign exchange 22 Feb 2018

Understanding a company’s FX risk

The headlines about the U.S. dollar this year have underscored how complicated it is to predict the movement of any one currency in a global economy. They’ve gone from grim (“Dollar set for worst January in 30 years”) to triumphant (“Dollar claws back”) to deflated (“Dollar’s rebound fizzles”) in a matter of weeks.

For companies that do international business, currency fluctuations can have far-reaching effects on their businesses. That’s why BBVA Compass recently assembled dozens of its Global Market clients in Houston – a hub for global businesses, with more than 3,400 companies in the city involved in international business — to walk them through the finer points of hedging against foreign exchange, or FX, risks. The purpose of the event was to bring together the bank’s experts in a forum for clients to help them make sense of the rapidly changing environment.

David Gill, director of Foreign Exchange Sales for BBVA Compass, said he’s often asked why clients should bother with hedging FX risks.

“Say a company makes its goods right here in Texas and sells them right here in Texas,” he said. “This company probably doesn’t think they have any need to hedge against foreign exchange risk. But what if the biggest piece of equipment they use is manufactured in Germany and they spend $500,000 every year for a new one? Depending on the exchange rate, they could be paying $575,000 for the same machine in a few months’ time. That’s FX risk.”

Gill divides the FX hedging process into several steps, starting with identifying the type of FX risk a company is exposed to. These risks fall into three buckets:

  • Transaction risk: This is the most apparent risk, Gill says, and occurs when there’s a delay between when parties agree upon a price and when payment is rendered. For example, say Company A is based in the U.S. and decides to sell goods to a French distributor, Company B. Company A then sends an invoice for 1 million euros to Company B for the price of those goods. The exchange rate at the time of sale was 1.09 euros for every U.S. dollar, but when Company A actually got paid three months later, the exchange rate had dipped to 1.04 euros per dollar. That’s a transaction risk: Even though Company A got paid that same 1 million in euros, there is a loss between the value of what it expected to get and what it actually received of about $50,000 USD ($1.09 million vs. $1.04 million).
  • Translation risk: This is also known as balance-sheet risk. It affects the valuation of foreign currency accounts and foreign subsidiaries, which in turn affects the consolidated value of the parent company’s balance sheet. Say Company A, a U.S. company, purchases Company B in the U.K. After the acquisition, Company B is able to increase sales and cut costs through synergies, and increase Company A’s overall value. But then the value of the British pound drops so drastically in relation to the U.S. dollar that the value of Company B also starts diminishing faster than its sales are increasing. Those changes in a company’s valuation can have ripple effects on Company A’s balance sheet. That’s translation risk, and it’s particularly relevant when a parent company has assets that are denominated in a foreign currency.
  • Economic risk: This is the risk effect that exchange rates have on domestic revenues (exports) and operating expenses (the cost of domestic inputs and imports). Gill said one of the most common misperceptions about such a risk, which isn’t an infrequent occurrence, is a company’s belief that it can minimize its FX risks by pricing goods and expecting payment only in U.S. dollars. “U.S.-based companies may think they’re getting rid of FX risk by only accepting payment in U.S. dollars, but they’re actually shifting that risk to the company in the other country,” he said. “In those instances, if there’s a rapid devaluation in the foreign currency, that foreign company may not be able to afford the U.S. dollars at the current exchange rate to pay them back.”

Once a company identifies its exposure to foreign exchange risks, Gill said the next steps are to formulate a currency management policy, determine a budget, build and execute a hedging strategy, and then review and adjust. Some of the FX products offered by BBVA Compass include Outright Forwards, Window Forwards, FX Swaps and FX Netting, all of which can set or fix exchange rates today for transactions that settle at a later date.

Gill: There are many solutions to mitigate FX risk, but there isn’t a one-size-fits-all approach. It really depends on a company’s tolerance for risk, their credit profile and what product works best for them.

“There are many solutions to mitigate FX risk, but there isn’t a one-size-fits-all approach,” he said. “It really depends on a company’s tolerance for risk, their credit profile and what product works best for them.”

Gill is part of a team based out of Houston that is able to pull from the global expertise of BBVA, BBVA Compass’ parent company. BBVA is based out of Spain and operates banks in more than 30 countries, including BBVA Bancomer, the largest bank in Mexico.

FX risk is something that we are familiar with, as we are part of a bank that’s been around for more than 150 years and operates in multiple currencies,” Gill said.

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