Foreign Exchange (FX) volatility should be actively managed

Passive versus active FX management

Passive FX management involves buying currency as needed and repatriating as soon as it’s earned. This type of unstructured and unexamined FX trading may create unexpected losses, increasing over time, as experienced recently by US-based innovation-sector companies that fund global operations with U.S. dollars (USDs).

After a decade and half of strength, the USD trend has reversed. Cooling inflation, lower yields, a rethinking of the structural overallocation to U.S. assets by global investors have put downward pressure on the USD, eating into purchasing power abroad and eroding the free cash flow, runway, and bottom-line earnings for exposed companies.

Surprises from exogenous sources can be avoided by adopting an active, as opposed to passive approach. Active FX management starts with awareness, analysis, and quantification - in other words – deploying time and resources to determine if the FX risk is material. If risk is deemed material, FX uncertainty may be reduced through the deployment of natural remedies such as asset-liability management and, if necessary, financial derivatives.

What is materiality?

Materiality is a function of two factors, size and volatility. The combination of these factors constitutes a company’s currency exposure.

Size corresponds to the amount of currency that must be transacted over a certain period. Generally, if a minimum of 20 percent of top-line revenues or operating expenses (OpEx) are projected to be realized in foreign currencies, then the “size” threshold is met.

Volatility measures the potential loss that would arise from adverse moves in exchange rates. This projection is generally currency dependent and can be based on historical patterns, or the current cost of insuring against those risks, and is generally associated with a level of probability.

For example, technology companies moving R&D to India will find that the value of the rupee versus the USD may swing from one period to the next - the longer the period, the larger the swings (e.g., historical average 10 percent, but have been as large as 30 percent). While the volatility threshold is met, the combination of size plus volatility will determine risk materiality. If projected India spend is 2% of total OpEx, then the FX risk is not material to the company. However, if the spend is 20% of total, then materiality exists, and it should be managed.

FX materiality checklist

Any of the following factors may indicate that your business has potential material exposure to FX risk.

• Where are your customers and vendors domiciled?
• What proportion of operating expenses are denominated in currencies other than the U.S. dollar? What is the mix of currencies?
• Do you have the ability to price in USD for your customers/vendors outside the US? How sustainable is this arrangement?
• If you cannot price goods or services exclusively in USD, what percent of revenues are denominated in foreign currencies? 
• If you are billing and collecting outside the US through a third-party payment provider (PSP), are they delivering USD or foreign currency? There are hidden risks to consider even if the PSPs are delivering USD.
• Are you operating out of cost-plus or standalone entities? What is the functional currency of these entities? Are you currently or do you expect to build-up large intercompany balances?
• What is your overseas profit repatriation strategy? Do you expect to hold currency outside the US for any reason?

The case for active FX management

FX risk is a by-product of doing business internationally, created the moment your corporate operations or capital crosses domestic borders. FX volatility is not within your span of control and generally works independently of any other value or cash flow stream. Active FX management involves adopting a mechanism for measuring the potential impacts to core business performance, determining materiality, and reducing the exposure to a level that is deemed tolerable. The rule of thumb is to exhaust all the natural risk mitigation alternatives first, then if appropriate, use derivatives to mitigate residual quantified risks.

Handled actively and strategically as an integral part of the financial planning & analysis (FP&A) process, active management of FX can help transform an unpredictable drag on your performance into earnings, margin improvement and total returns.

If you’d like to discuss your specific situation to determine FX materiality or to explore the merits of active FX management, email GroupFXRiskAdvisory@svb.com or reach out to your SVB FX contact directly.