Currency risk in international trade in the COVID-19 era - what every entrepreneur should know

An increasing number of Polish companies enter foreign markets with their products. There are also those that primarily import and/or export, establishing cooperation with international customers or suppliers.

In the era of a global pandemic, international contacts have become very restricted, some have even been suspended. However, the current crisis will finally pass and products and services will again start to flow between countries. However, the benefits of international trade are not free of currency risk.

Fortunately, a properly designed foreign exchange risk management strategy can help any company to hedge against it. It won't eliminate the risk completely, but it can help entrepreneurs protect themselves from risks that could adversely affect their bottom line.

 

Volatility analysis and risk identification

Preparations for strategy development should start with an analysis of the currency risk to which our company is exposed. Currency exchange rate fluctuations are among the least predictable factors in international operations. The higher the international turnover, the higher the currency risk incurred by the company. This becomes even more important during periods of market instability e.g. in the face of the current pandemic. Therefore, risk analysis requires observation of the volatility of the currency pair in question, which shows how much the exchange rate can change in a given unit of time.

The next step is to audit the sales or purchase processes and identify the moment when currency risk occurs. Our experience shows that many entrepreneurs only start thinking about it when they receive or issue an invoice, whereas this risk most often appears as early as during the forecasting of purchases or sales, before the preparation of a price offer.

Strategy development

Unfortunately, there is no currency risk management strategy perfect for all companies. Its structure and duration depend on the specifics of the company and it should be developed after an in-depth analysis of the cost and revenue structure as well as the company characteristics. Experts distinguish two general approaches to risk management: passive and active. In the former approach, our financial result does not depend on the market at all, we eliminate currency risk, but we also lose the opportunity to benefit from positive exchange rate fluctuations. The active approach involves the use of more adaptable instruments, which allow us to participate in positive market changes, but often involve higher costs and/or risks. The third alternative is, of course, the absence of any strategy.

The range of instruments

Regardless of its type, the strategy often involves the most popular instruments, i.e. forwards and currency options. Forward contracts allow for "rigid" hedging of the exchange rate, i.e. regardless of future changes on the currency market, the company already agrees with the bank the rate at which it will settle the transaction in the future. A currency option, on the other hand, gives you the right, but not the obligation, to buy or sell the chosen currency for another on the settlement date in the future. Currency options also enable to build more flexible structures to hedge the company's individual currency risk, taking into account specific settlement dates, volatility and exchange rates .

4-step strategy

To sum up, the development of a risk management strategy can be divided into 4 basic steps. The first one is to identify risks and compare the current exchange rates with the budget rate of the company. Then the main objectives to be achieved should be established and the impact of volatility in the given currency pair on the company's margin should be estimated. The next step is to build a strategy consisting of e.g. a set of instruments described above. The process completes the implementation of the strategy.

Fluctuations in the FX market are impossible to predict, but by implementing an appropriate FX risk management strategy, business owners can survive the economic turmoil and secure a steady position in the competitive market. It seems that looking at the last few weeks and how economic life can change from one day to the next, it is worthwhile to devote at least some attention to aspects related to the broadly understood financial risk in the company's operations

Disadvantages and risks

If a customer is uncertain about the direct impact of forwards or currency options (hedging instruments) on his their management strategy, we recommend not using them. All contracts remain active once they have been confirmed, so you usually lose the opportunity to participate in positive market developments with regard to the hedged amounts up to certain dates in the future. There is also no possibility to withdraw from the contract. If a client decides to terminate, for example, a forward contract, he will be exposed to a loss or profit, depending on the current exchange rate at the time of termination. Foreign exchange markets are highly volatile. It is important to remember this.

Autor: Michał Buczko

Senior Business Development Manager Western Union Business