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The Australian Government's foreign exchange risk management policy has been in place since 1 July 2002. This policy applies to all Commonwealth entities in the general government sector (GGS). The policy applies to both departmental and administered funding. Foreign exchange risk is the risk that an entity's financial performance or position will be affected by fluctuations in the exchange rate between the Australian dollar and other currencies. The overarching principle of the policy is that GGS entities are responsible for the management of their foreign exchange risks. However, the entities must not act to reduce the foreign exchange risk that they would otherwise face in the course of their business arrangements. To assist GGS entities in managing foreign exchange risk, Finance has published the Australian Government Foreign Exchange Risk Management Guidelines, which provide in-principle guidance to entities, and may also be used as a benchmark to assess entities' foreign exchange risk management practices.
Written by: Rylan Dawes, VP of FX Product, Airwallex Any currency can experience periods of high volatility. The current COVID-19 situation is introducing levels of volatility in foreign currency markets not seen since the 2008 Global Financial Crisis. These levels of volatility can make or break a business that relies on importing or exporting goods, however, you can minimise these risks by having the right measures in place. What is foreign exchange risk?In simple terms, foreign exchange risk is the risk imposed on a business’ financial performance by changes in currency exchange rates. These fluctuating exchange rates can damage a business’ profitability by eating into margins. Sources of foreign exchange riskEssentially, any situation in which a business uses foreign currency can be considered a foreign exchange risk. But businesses that deal with more than one currency are more prone to foreign exchange risk than others. These risks can come from:
The danger for businessesThere are a number of ways that volatile foreign exchange can impact your business. For example:
But while typically volatile exchange rates can make a business nervous, there are a number of proven strategies that enable effective hedging against foreign exchange risk. Managing foreign exchange riskSpot transactionsSpot transactions, or spot contracts, are probably the easiest way to manage foreign investment risk. A spot transaction is a single foreign exchange transaction, where you purchase and settle the amount ‘on the spot’ (or rather, within two business days). It provides very little notice time, and a shorter window for risk, so if you’re happy with the current foreign exchange rate, you can book in a conversion with a spot transaction. While this might mean you forego a better rate in the future, it does minimise the risk of future volatility in your desired foreign currency right now. A Forward Exchange Contract (FEC)A FEC allows your business to guard itself against price fluctuations by locking down an exchange rate at the current price, which is valid until a date set by you. While this contract provides peace of mind that you won’t actively lose money on your foreign exchange, it does mean that you can’t take advantage of any positive shift in foreign exchange rates. Another downside is the fees imposed on this contract. A FEC locks in a specified sum of money. So for example, if you lock in US$10,000, but at the end of the contract you only needed US$8,500, then there is a contractual cost to cancel this remaining portion. Natural hedgeFor businesses that are already selling overseas (for example in the US), foreign currency bank accounts can also provide a great way to provide a natural hedge. For these businesses, rather than receiving in USD and converting to AUD, you can leave your USD balance in your USD foreign currency account. This is especially convenient if you have expenses also in USD as you can hedge against any fluctuations in AUD by just holding USD in your account. You also save on any potential double conversion fees the banks may charge (for example, converting from AUD to USD and then back to AUD). Foreign currency bank accountsA simple way to manage foreign currency risk involves setting up a foreign currency account. Then, to hedge against risk, simply deposit the required amount (plus a nominated surplus) into the account. This method allows you to make the most of FX rates when they’re strong, by converting and holding the foreign currency until you need to make payment. It also ensures the correct funds will always be available and takes into account the potential fluctuations of the currency. If you need help managing your businesses’ foreign exchange risk, why not sign up today and book a time with one of our product specialists who are more than happy to assist. Related article: Understanding the interbank exchange rate Our products and services in Australia are provided by Airwallex Pty Ltd ABN 37 609 653 312 who holds AFSL 487221. Any information provided is for general information purposes only and does not take into account your objectives, financial situation or needs. You should consider the appropriateness of the information in light of your own objectives, financial situation or needs. Please read and consider the Product Disclosure Statement available on our website before using our service.
The simplest risk management strategy for reducing foreign exchange risk is to make and receive payments only in your own currency. But your cash flow risk can increase if customers with different native currencies time their payments to take advantage of exchange rate fluctuations. You might also lose customers to competitors who offer more currency flexibility and your suppliers may be unwilling to accept payments in what is to them a foreign currency. So you may therefore find that competitive pressures force you to explore a risk management strategy that helps manage your foreign exchange risk more efficiently. Simple FX hedging involving currency forward contracts is the heart of FX risk management strategies for many businesses and is built into their FX international payments platforms. Currency forward contracts "lock in" the exchange rate of a future payment in a foreign currency. For example, suppose you are an Australian importer of British woollens and have just ordered next year's inventory. Payment of £100M is due in one year, which at an AUD/GBP exchange rate of 0.5 means a dollar outflow of $200M. But if the exchange rate moves to 0.45, your inventory cost in dollars will increase by $22m, which could mean a hit of over 10% to your bottom line. To avoid this exchange rate risk, you could enter into a forward contract to buy £100M sterling in a year's time at today's exchange rate. If you have a series of foreign currency payments to make – for example, if you are paying for supplies through an open line of credit arrangement – you could opt for a "window forward" contract, where exchanges may be made “on or before" a particular date. If your exposure extends over a long period, you could consider flexible forward contracts on a historical rolling rate basis. This risk management strategy allows you to enjoy exchange risk protection beyond the typical timespan of simple forward contracts. Forward contracts lower foreign exchange risk and give you income certainty, but they prevent your business profiting from favourable exchange rate movements. You could build profit potential into your FX risk management strategy by judicious use of derivative instruments such as options and swaps. However, they can be expensive and difficult to unwind when no longer required. You may find that careful management of foreign currency cash positions with the support of a good FX service provider gives you greater flexibility and reduces your foreign exchange risk. You can bring forward or delay payments to limit the impact of adverse exchange rate movements or benefit from favourable ones. If you are doing business in multiple currencies, you could also time payments and receipts to offset currency positions for currencies that tend to move together, such as yen and yuan. Real-time rate alerts on an FX international payments platform can help you manage the timing of payments to suit your foreign exchange rate risk appetite. |
Methods of managing foreign exchange risk
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