In the context of foreign exchange risk, hidden FX risk refers to the amount of accounting, transaction, or operating exposure that has not been appropriately identified. The largest problem in managing FX risk is a lack of transparency and trustworthiness in FX forecasts.
FX swings induce earnings volatility, which can have a significant influence on risk management decisions if organizations do not have sufficient capabilities for identifying and quantifying that volatility.
FX exposures can be difficult to detect because they appear on a company’s balance sheet and in multiple intercompany transactions. To identify mishaps, companies must dig deep into their balance sheet exposures and estimate cash flows in order to extract the tiniest bits of information about transactions that occur at the corporate and subsidiary levels.
Forms of hidden FX risks
Foreign exchange risks can be derived from a variety of sources, including internal activities such as accounting, trading habits, and technology, as well as external influences such as currency volatility.
When a company’s treasury function places hedges without knowing about existing offsetting vulnerabilities, that’s an example of mishedging or inadvertent speculation, which is an internal vulnerability that’s not always obvious.
In general, there are three kinds of FX exposures:
Transaction exposure: Taking loans denominated in foreign currency, depositing in foreign currency, accepting payments in different foreign currencies, as well as other FX financial transactions, might expose you to FX transaction risks.
Net investment exposures: They are the risks associated with holding foreign-currency subsidiaries, with consolidating their worth resulting in exchange disparities in the accounts. In terms of cash flow, a foreign subsidiary might be considered an FX asset.
Economic or strategic exposures: They arise from the competitive environment of the business; for instance, a company may be disadvantaged in a market where the competitor trades in a different base currency e.g. paying salaries in foreign currency may result in substantial savings if that currency is stable.
Common mistakes in handling FX exposure risk
- A company’s capacity to manage FX exposure can be hampered by producing compartmentalized and sluggish decision-making. As a result, this can lead to misidentification of FX exposures.
- Multiple systems and switchovers: Inconsistent treasury systems can increase the amount of time spent on manual reconciliations, as well as reduce the overall scope and timeliness of risk reporting.
- Failure to recognize offsets that occur naturally: It’s possible that this will lead to the corporation hedging its net positions, increasing hedge costs, and possibly leaving them blind to their underlying risks.
- Intensely manual procedures: Reduced time for analytics due to an inefficient resource model could have a negative influence on FX risk management. A manual method might also lead to more errors and impede the flow of information within the company. As a result, instead of proactively managing risks, a large amount of work is spent keeping systems afloat.
- Enterprise integration: Managing foreign exchange risk might be hampered when there aren’t uniform processes in place across the different levels or departments of a company. Multi-currency transaction processing, for example, may differ substantially between business units when it is decentralized, especially in multinational businesses that are growing rapidly. This creates issues when a corporation attempts to maximize the efficiency of its foreign exchange operations.
- Analytics based on large amounts of data and sophisticated models: There are several challenges that can arise from using subpar systems or processes, including the inability to react quickly to changing data and inaccurate assessments of operational changes and market events. This results in an FX analysis that is not fully integrated into the decision-making processes.
- Misalignment between FX policy and the board of directors: Derivatives and the complexities of FX risks are often unknown to many boards. Misaligned incentives and measures can also impede a company’s overall FX risk management program, as can KPIs and standards created from those data.
Handling exposure through FX hedging
Hedging is a common strategy for managing foreign exchange risk. Some or a combination of the following formats is usually used:
- Selling the exposed currency forward against the base currency for sales and future inflows is referred to as forward hedging (and the opposite for purchases and outflows). FX risk can be hedged in the most cost-effective method possible.
- To hedge foreign business against currency fluctuations, you can borrow the currency of the sale and repay the loan with future cash outflows. You can do the inverse by depositing purchase currency. This is also effective when there is no or very limited forward market.
- Natural hedging: A natural hedge is when you acquire goods or services in the same currency that you sell in to protect your investment. Even though it appears to be a simple answer, this is not always the case because suppliers and customers may value the FX risk result more than the company does. Due to the difficulty of changing commercial agreements, natural hedging is less adaptable than simply using forward contracts.
Hidden FX risks are often not hidden as such but can easily be unearthed through a more detailed look into company currency transactions. It is important to put in place appropriate measures to prevent or hedge against these risks because they can adversely affect profitability and lead to poor decision-making.