Mid-sized companies increasingly look globally for new customers or suppliers. As a result, they may pay or collect in a non-functional currency. But FX rates change all the time; ignoring volatility isn’t avoiding complexity – it’s making a potentially costly bet on a currency pair.
In addition, some companies fail to consider FX costs. Early stage companies in particular may use cross-border wires for payments and view the premium on the spot price as an unavoidable cost of doing business.
Later stage mid-cap companies sometimes ignore FX risks and costs for other reasons. For instance, some grow by acquisition and inherit multiple bank relationships, while others have a decentralized structure with locally-managed payments.
Either way, companies run the danger of failing to understand FX risk if they work with multiple banks. They might also miss out on the lower costs available when consolidating volumes with a single provider.
Understanding balance sheet flows
Companies of all types and sizes need to regularly assess FX risk. As your company grows and evolves, your payment needs change – with knock-on consequences for FX exposures. For early-stage firms, the trigger to hone in on FX could be that aggregate volumes reach a meaningful size or additional FX corridors are added. For mid-sized companies, it could be an M&A in a new geography.
To take a more proactive approach to FX, you need to understand your operational flows, especially those that are cross border. This can be tricky for early-stage companies. Payments and collections are often ad hoc, so your visibility is limited. However, the predictability of balance sheet cash flow usually increases as your client base becomes more stable. You could then start taking a more strategic approach to FX by:
Scrutinizing your balance sheet for non-functional currency transactions. These will change in value relative to your functional currency, potentially generating gains and losses that have an outsized financial impact on margins.
Prioritizing the largest FX exposures which would cause the most pain if a currency pair moves against you. You might only have balance sheet visibility out to 30-days, but by hedging for even a month, you could mitigate risk.
Why forecasting is crucial to risk management
While your flows beyond 30 days may be less predictable, all companies make regular operational forecasts throughout the year. In addition, long-term contracts with overseas customers and suppliers provide a degree of certainty.
Armed with this knowledge, you can make assumptions about your need to buy or sell certain foreign currencies at specific points in the future and integrate FX into your regular operational forecast.
Forecasting can be done in a spreadsheet but ideally needs to leverage an appropriate solution. Cash-strapped mid-cap companies don’t need to spend big. Some banks provide cash flow forecasting products or integrate with popular solutions.
For instance, Citi’s Treasury and Trade Solutions recently announced a partnership with Treasury Intelligence Solutions (TIS). Mutual clients can now access to TIS' cash forecasting and working capital platform through Citi solutions. (read press release - here)
You may be conservative about forecasting reliability initially, with only a reasonable idea of your requirements over just the next three months, for instance. But over time, forecasting reliability usually improves.
By integrating your operational forecasting with an assessment of FX requirements and exposure you can create an FX risk management strategy, typically with three components:
The spot price
Predicted FX movements for your most important currency pairs (based on forward curves)
Mark-to-market prices for your current hedges
These three components give you the foundations necessary to manage FX risk effectively and significantly increase the likelihood of achieving your financial goals.
Creating a hedging strategy
Most companies may benefit from gaining a more holistic view of exposure as part of an FX risk management strategy. It provides greater certainty of flows and makes it easier to achieve your operational objectives.
However, there is no one-size-fits-all solution when it comes to managing FX risk. Each company has different exposures and risk tolerances and these will change over time. Your hedging strategy should evolve as your volumes and operations change.
The goal is not to predict the future but to limit deviation from earnings guidance caused by FX fluctuations and enable time to adjust prices during periods of extreme FX volatility.
It’s normally better to hedge as far forward as you can. Visibility after a certain period is inevitably limited and any hedging choices should reflect that lower certainty (you may seek to hedge only 50% of exposures, for instance). You may also run up against credit limits with your bank beyond a certain time horizon.
Working with the right partner
By working with the right partner, you can have payment flexibility and access to tools that will help you better understand your FX risk. For mid-cap companies working with multiple banks, consolidating flows to a single provider can be a valuable first step to lowering costs and improving visibility.
Firms should build relationships with a provider that combines global payment capabilities with in-depth expertise in the FX market for solutions that are consistent and locally relevant. While it can be tempting to focus solely on price when it comes to FX, quality and breadth of offering – evidenced by on-the-ground capabilities – are also important.
Citi has a global network covering nearly 100 countries and direct membership of around 400 clearing systems. Our payment capabilities are scalable and flexible, so we can respond to your changing needs quickly.
In the FX market, Citi has trading desks in 77 countries. This, combined with our global network and the fact we do business in nearly 160 countries, means we can give clients local advice and tailored solutions in almost any country and any currency in the world. Furthermore, Citi’s Corporate Sales and Solutions Risk Management team can help clients to quantify risks on their balance sheets for cash flow analysis.