Managing Your Foreign Exchange Risk

Once you have a clear idea of what your foreign exchange exposure will be and the currencies
involved, you will be in a position to consider how best to manage the risk. The options available
to you fall into three categories:
• Do Nothing: You might choose not to actively manage your risk, which means dealing in the
spot market whenever the cash flow requirement arises. This is a very high-risk and
speculative strategy, as you will never know the rate at which you will deal until the day and
time the transaction takes place. Foreign exchange rates are notoriously volatile and
movements make the difference between making a profit or a loss. It is impossible to properly
budget and plan your business if you are relying on buying or selling your currency in the
spot market.
• Take out a Forward Foreign Exchange Contract: As soon as you know that a foreign
exchange risk will occur, you could decide to book a forward foreign exchange contract with
your bank. This will enable you to fix the exchange rate immediately to give you the certainty
of knowing exactly how much that foreign currency will cost or how much you will receive at
the time of settlement whenever this is due to occur. As a result, you can budget with
complete confidence. However, you will not be able to benefit if the exchange rate then
moves in your favour as you will have entered into a binding contract which you are obliged
to fulfil. You will also need to agree a credit facility with your bank for you to enter into this
kind of transaction.

• Use Currency Options: A currency option will protect you against adverse exchange rate
movements in the same way as a forward contract does, but it will also allow the potential for
gains should the market move in your favour. For this reason, a currency option is often
described as a forward contract that you can rip up and walk away from if you don't need it.
Many banks offer currency options which will give you protection and flexibility, but this type
of product will always involve a premium of some sort. The premium involved might be a
cash amount or it could be factored into the pricing of the transaction.
Finally, you may consider opening a Foreign Currency Account if you regularly trade in a
particular currency and have both revenues and expenses in that currency as this will negate to
need to exchange the currency in the first place.
The method you decide to use to protect your business from foreign exchange risk will depend
on what is right for you but you will probably decide to use a combination of all three methods to
give you maximum protection and flexibility.