Managing this FX risk faced by importers and exporters all over the globe today is a three-step process: identify FX risk; develop a strategy; and utilized the proper instruments/strategies to hedge the risk.
Identify FX Risk
As explained in the previous blog post, the most common type of risk faced by firms is transaction risk. For a New Zealand exporting company paid in Australian Dollars, measuring FX risk entails determining how many Australian Dollars it expects to receive over the coming quarter (whatever the period of business may be), versus the money the New Zealand firm will need to make payments in Australian Dollars over the same period. Simply put, this difference is the amount that needs to be hedged.
Developing a Strategy
Developing a hedging strategy necessitates that the following questions be answered: when should FX exposure be hedged; what tools/instruments are available under the current circumstances; and how will the performance of the hedge be measured? Developing a strategy is contingent on where in the process a firm is (see flow chart below).
Using the Proper Hedging Instrument
Implementing the proper hedging strategy involves a review of the company’s policies as well as the intentions of the hedge. Hedges can vary from something simple like purchasing the foreign currency, to more round about ways like purchasing commodities in the country where the company’s products are sold.
We will discuss different types of hedges – what the proper hedging instrument is – in the next post.