In today's business environment, escalating a technology company into the international marketplace may no longer be just an option, but a necessity for growth. However, like any significant endeavor, conducting business across borders also has its challenges. As you can imagine, every country has its own laws, accounting rules, taxes and regulations governing businesses. To complicate expansion even more, technology firms that import and export may also find foreign exchange (FX) to be one of the most difficult and challenging aspects of doing business abroad.
Over the past six months, the FX market has experienced more than its share of volatility. The euro (EUR) has traded off a recent low of 1.38 (set in June) before trading up to a recent high near 1.52 in early December. During the same time period, the Great British pound (GBP) is looking less great, gyrating in an 8-percent range and nearly 7 percent off its highs. Meanwhile, on the other side of the globe, the U.S. dollar (USD) has also fallen against most Asian currencies. The USD is 10 percent lower against the yen (JPY) from this year's low of around 100 and nearly 8 percent lower against the Indian rupee.
There are many factors contributing to such market movements: interest rates, global economic growth, inflation and commodity prices, just to a name a few. We must remember that accurately predicting the future value of any currency is a very difficult challenge. Some experts suggest we could be headed for a new, stronger phase for the USD, while others are predicting the USD will slide to new lows. That is a discussion for another day. Today, the only prediction I am willing to put forth is that it appears the future will bring more of the same uncertainties — maybe. This unpredictability of the foreign exchange rates underscores the economic importance of minimizing currency risk.
One basic question must be answered: Is any adverse effect on the FX rates going to have a material impact on your income statement or balance sheet? If your answer is "yes", you must seriously consider reducing the effect of FX volatility on your business. Remember, FX volatility exposes corporations — which typically have investments, expenses, and revenues in more than one currency — to significant risk. How will another 10-percent swing in the USD affect your profit margin? What about a 30-percent move? If unmanaged, this risk can lead to undue earning volatility and cash flow uncertainty. The alternative is to avoid overseas opportunities. However, for technology companies, playing in the global sandbox is a prerequisite, and that means dealing with risks of foreign exchange.
My own experience leads me to realize that managing risk is the right thing to do. A prudent CFO once shared with me, "I never want to explain to the CEO, board members, shareholders or stock analysts that the company failed to meet earnings estimates because of adverse movements in the USD."
Of course, like any endeavor, there will be speed bumps on this road to financial responsibility. So, before you call me to purchase that EUR put option, it makes sense to do your homework. Your first step is to garner a complete, objective picture of your FX risk. From which business activities is the exposure derived? What products are available to help with this specific risk?
Creating a Foreign Exchange Policy
Once a risk has been thoroughly analyzed, the next step is to create a formal policy for the management of foreign exchange exposure. This process will help you examine accounting and cash flow implications, but will take into consideration your risk tolerance and corporate goals. The FX policy should be a streamlined document that is easy to read and provides practical guidance. FX policies are generally tailored to the specific needs of the company, although all policies should provide a framework for corporate decision making while providing specific guidelines for implementing FX risk management. The company's board should approve the policy, upon completion. It is important to remember that a policy is a living document and should be reviewed at least on annually to ensure that it meets current corporate objectives.
Most policies should include these four common components:
1. Objectives
Objectives should be clear, concise and relevant. They should include the financial goals, exposures to be hedged, and management's tolerance for risk, and may even specify dollar amounts to be hedged. Certain questions should be addressed, such as whether to hedge cash flow, balance sheet or earnings.
2. Responsibilities
This should include which individual(s) in the organization have authorization to hedge on behalf of the company. The latest trend has been to keep most of FX risk management functions in one central office. You also should identify: 1) who are the members of the foreign exchange committee and how often the committee meets, 2) who reviews derivatives and when derivatives reviewed, and 3) what levels of management approval are needed for various exposures (i.e., short-term versus long-term risk) and trades.
3. Control
This is an operational issue that typically should define operational aspects such as reporting responsibilities, mark-to-market results, when and who should inform management of FX activity, how trades are confirmed and by whom, and whether the FX manager is within counterparty credit limits. You may also include documentation requirements for accounting purposes.
4. Strategies
This typically includes the types of derivative products that can be used. Can you only use forwards? Do you want to buy options or sell options? Can you use a combination of options to reduce premiums? All of these parameters must be defined and explicitly approved. Specify whether you will use a passive approach or whether your authorized individual(s) may use some discretion in a more active style.
The fact remains, FX rates are very difficult to predict. At the same time, foreign exchange is a reality in today's business environment. The first step is recognizing you cannot afford to be a speculator when it comes to participating in the FX markets. Remember, doing nothing to protect your income statement from the currency market is risky. This is even more important when your business is filled with a so many other risks and uncertainties. There is no better time to get started than now.
The views expressed in this column are solely those of the author and do not reflect the views of SVB Financial Group, or Silicon Valley Bank, or any of its affiliates. This material, including without limitation the statistical information herein, is provided for informational purposes only. The material is based in part upon information from third-party sources that we believe to be reliable, but which has not been independently verified by us and, as such, we do not represent that the information is accurate or complete. The information should not be viewed as tax, investment, legal or other advice nor is it to be relied on in making an investment or other decisions. You should obtain relevant and specific professional advice before making any investment decision. Nothing relating to the material should be construed as a solicitation or offer, or recommendation, to acquire or dispose of any investment or to engage in any other transaction.
Foreign exchange transactions can be highly risky, and losses may occur in short periods of time if there is an adverse movement of exchange rates. Exchange rates can be highly volatile and are impacted by numerous economic, political and social factors, as well as supply and demand and governmental intervention, control and adjustments. Investments in financial instruments carry significant risk, including the possible loss of the principal amount invested. Before entering any foreign exchange transaction, you should obtain advice from your own tax, financial, legal and other advisors, and only make investment decisions on the basis of your own objectives, experience and resources.