Common mistakes in the world of currency risk management
From time to time we hear news about large corporations reporting losses as a result of FX volatility, sometimes even as a result of poor FX risk management decisions. TFG heard from Adam Stark, Director at Central FX to find out more.
From time to time we hear news about large corporation reporting losses as a result of FX volatility, sometimes even as a result of poor FX risk management decisions.
Although less public, these challenges are even more common among SMEs. Financial teams of many small and medium-size companies have often no deep knowledge of how to properly handle their currency exposures or properly run hedging strategies and in such circumstances hedging mistakes are easy to make and can be very costly.
Below, find 4 common hedging mistakes that plague many small and medium-sized businesses that acknowledge the importance of hedging, but execute it incorrectly:
- Wrong evaluation of the exposure
- Lack of structured, long term hedging strategy
- Misunderstanding of hedging transactions goals and implications
- Inconsistent hedging strategy implementation
A. Wrong evaluation of the exposure
Frequently, hedges are performed without full understanding or analysis of the exposure and its impact on company’s financials. Similar to taking the drug without diagnosing the disease…It will make short term symptom disappear, but will not solve the problem and in some cases will end up with complications.
Among common mistakes in this area are:
- Misunderstanding of the risk term and wrong conception on when the risk starts and when it ends.
- Misunderstanding of company’s pricing models and their FX implications.
- Currency of the estimations – Usually it is the usage of the estimations in company’s currency instead of the original currency of the cash flow that causes inaccuracy over time
B. Lack of structured, long term hedging strategy
Due to many factors, SMEs hedging decisions are often made out of the immediate need, “gut feeling” about the market, pressure from the FX providers of fear of short term loss. There is no structured, long term approach towards the FX risk management. Bottom line, if there is no structured strategy behind it, 80% of the decisions will be driven by phycology which can be wrong, time consuming and extremely hard to explain to the management when questions are asked.
C. Misunderstanding of hedging transactions goals and implications
In many cases there is no full understanding of the purpose of the hedging tool, its mechanism and its implications. Over time companies forget why they entered the hedging transactions and evaluate their performance as a separate asset that creates profits and losses both economically and from the accounting perspective. This may lead to transactions cash flow management (closing hedging transaction when profitable) and even stop hedging when hedging transactions show losses. Some companies choose not to hedge its economic risk due to accounting implications.
D. Inconsistent hedging strategy implementation
It is hard to find an optimum hedging strategy and even harder to implement one long term.
Many factors can impact consistency, like market conditions, management pressure and time that needs to be invested to “make it right”.
Unfortunately, there are no short cuts and without ongoing management, even well-designed hedging plans will collapse, leaving the company with the risk, or even increasing the risk.
This of course is a time consuming process, if done manually, and demands a certain discipline but necessary.
To address these and many other challenges of the FX risk management we introduce Hedgemaster, a financial risk management software platform designed specifically for Corporate Finance and Treasury teams. It helps companies get real time data and insights on their currency risks and exposures so that they can design optimal protection plans to efficiently mitigate currency risks.
Central Fxs Hedgemaster enables companies to understand the FX risk they face, given their business model, analyze its impact and easily design an optimum and structured hedging plan. It also allows to automate daily tasks related to the FX risk management, replace complex excel spreadsheets and eliminates mistakes in this important business area thus making the implementation of the hedging strategies both effective and efficient.