Currency risk in the company
When buying or selling goods or services abroad or when selling them to foreign customers, we are exposed to currency risk. Adequate knowledge of exchange rate risk management helps to stabilise the trading margin, which depends on the final exchange rate.
Example of exporter:
The company sells mechanical parts for agricultural machinery to a client in Germany. It takes six months from inquiries or orders, production and delivery of equipment to payment. Assumptions:
- At the moment of calculating the contract, the EURPLN exchange rate was 4.2500.
- The company’s operating margin is 10% (EUR 10,000).
- The value of the contract is EUR 100,000.
At the moment of placing an order, the exchange rate increased to 4.2700, which means that the potential revenue of the company can be estimated at additional 2000 PLN (0.02 PLN x 100,000 EUR). Unfortunately, the advance payment is only 10% of the full amount. After six months the time to pay the rest comes up. Unfortunately, after a round of interest rate increases in Poland, the exchange rate dived to 4.1850.
In the final account, the company lost 7.5 grosz from the budget exchange rate. In this situation, the company loses PLN 7500 (0.075 x EUR 100.000 = PLN 7500), i.e. the final operating margin is almost 20% lower.
Of course, the exchange rate could go up and the company could then earn 7500 PLN more. However, we can never predict this to be 100% and keeping an open currency position (as in this example) will always have an impact on the final margin. That’s why it’s worth reading what’s below about currency risk management.
Example of an importer:
The company imports food products from Italy to Poland. To date, it has never applied an exchange rate risk management policy. Four months past from the moment of placing an order to the final payment. Assumptions to the example:
- At the time of calculating the contract, the USDPLN exchange rate was 3.8000.
- The company’s operating margin is 5% (US$5,000).
- The value of the contract is USD 100,000.
The company paid an advance payment for a dollar of 3.7900 (i.e. it additionally earned one grosz to the budget exchange rate). This means an additional revenue of 1000 PLN).
After four months the company pays for the goods received. The dollar-zloty exchange rate increased to 3.9000, which means that the company loses 10 groszy, which translates into a decrease in trade margin by 10,000 PLN (0.1 PLN x 100,000 EUR = 10,000 PLN). As a result, the company loses about 60% of its trade margin. As can be clearly seen, the lack of currency risk management policy contributes to the company’s profitability fluctuations.
Of course, the opposite could be the case. The company could earn extra profit. But is it really an entrepreneur’s job to be helpless in the face of currency risk?
How to manage your company’s currency risk?
There are many financial instruments and other techniques that help to eliminate currency risk. The most frequently chosen way to manage the company’s currency risk is FX forward transactions.
Forward transactions are conducted with the bank by contacting a corporate dealer most often working in the Treasury Department of a bank. In order to get in touch with such a person, please contact your Customer’s Advisor, who will pass the contact details.
Below I present how forward transactions work.
What are forward transactions?
Forward transactions help to manage currency risk. This is a contract under which you agree with the bank to buy or sell a certain amount of currency at certain, fixed date. Example:
You sign a contract with a bank to sell EUR 55,000 in 60 days from today at a rate of 4.3020. Whatever happens, you are obliged to settle the transaction: this amount, this rate, on that date.
- No matter what happens in the currency market, you have just stabilized your trading margin in the context of exchange rate change.
- It doesn’t matter if the exchange rate goes up or down – you’re already free from that risk – you’ll earn about as much as you planned in the beginning.
Forward transactions are the basic instrument that hedges the company’s currency risk. Before you can make your first transaction, you need to obtain a treasury limit at a bank, where the procedure is the same as for a credit limit. You will be presented all this by a corporate dealer in a bank that deals with currency and currency risk.
The greater the amount of foreign currency exposure (purchase and sales needs) you hedge, the more you reduce the value of your open currency position, thanks for which you will reduce your company’s vulnerability to currency volatility.
How to conduct forward transactions – general process
- Contact your Customer Advisor at the Bank – she / he will pass the contact to the dealing room at the bank
- You will receive information from the bank on the benefits and risks associated with FX risk management and individual instruments, including information on FX forward transactions.
- You will be allocated a treasury limit by the bank (the process of being granted a similar credit limit), thanks to which you will be able to conduct forward transactions.
- Execute your first forward transaction
- You will settle or change the settlement date of the forward transaction
We recommend that you continue below:
Article – Learning from five mistakes made by customers entering into forward transactions. Improve currency risk management.
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