How to Manage Currency Risk

Exchange rate fluctuations are a constant headache for expatriates the world over. The strengthening or weakening of their home currency against the Thai baht could mean that their pension, investments or savings from home could become more or less valuable.

How to Manage Currency Risk

Exchange rate fluctuations are a constant headache for expatriates the world over. For the many people who have chosen to retire in Thailand, the strengthening or weakening of their home currency against the Thai baht could mean that their pension, investments or savings from home could become more or less valuable. For the working expat, sending a fixed amount of baht home to your family or to pay bills could equate to more or less of your home currency from one day to the next. Even just a couple of satang’s change can equate to large differences when substantial sums are being moved. If it’s a big change, it can potential spell the end of your way of life in Thailand.

The risk is multiplied when it comes to running a business with overseas customers and concerns, not least because the sums involved are also multiplied. Fortunately, while there are plenty of risks you need to consider when it comes to foreign exchange, there are ways in which you can mitigate those risks, reducing their impact and minimizing your losses.

What are the major foreign exchange risks?

Ultimately, the risks faced by companies that on foreign exchange as part of their business boil down to three types:

• Transaction exposure

• Translation exposure

• Economic (also called ‘operating’) exposure

Each works in a different way, and we will take a closer look at each to find out how.

What is transaction exposure?

As its name suggests, transaction exposure is the risk that a company is exposed to during a business transaction involving foreign currencies. This is most often a result of the time it takes to complete that transaction. For example, the time between a purchase order being issued and the invoice being settled could be days, weeks or potentially even months. In that time, the strength of one currency relative to another could radically change, making the cost to the company significantly higher or lower than it was before.

For example, a Thai business ordering a product or service from the UK may place an order valued at £100,000 on a day when £1 will buy 38 baht, making the order worth 3.8 million baht. In the months that follow, the pound could strengthen or the baht weaken to the point that £1 is worth 40 baht. With the invoice now due for payment, the order will cost 4 million baht - 200,000 baht (or £5,000) more than originally planned.

What is translation exposure?

Translation exposure is only really a risk to multinational companies since it comes from the requirement of the parent company to report to shareholders and regulators of all of its overseas subsidiaries. Most importantly, the report must use the currency of the country in which the report is being issued. So, for example, a US company with a regional office in Thailand must list the subsidiary office’s profits and losses in US dollars, despite the fact that the money being reported on is in Thai baht and the value of that baht in dollars will vary from minute to minute.

On a balance sheet listing earnings in the millions of dollars, a variation of even a single satang could have enormous implications. For example, it could conceal or exaggerate the rate at which a company’s performance is growing or declining. Investors and shareholders could potentially make decisions regarding the fate of that company based on data that, while accurate at the exact moment the numbers were gathered, is not truly representative of the company’s performance. Depending on where the company’s head office is located, this could also result in an increased or reduce rate of tax on overseas earnings (though this does not apply in the US, which doesn’t have such a tax).

What is economic exposure?

Economic exposure is an added risk that businesses have to consider when devising their long-term strategy. The change in foreign exchange rates over the course of years and decades can be huge - for example, £1 was worth about 70 baht in the mid-2000s, but was down to around 55 baht just 10 years later and about 40 baht as we enter the 2020s. The returns from any significant investment in another country will therefore be extremely difficult to predict and project over even just a few years, making it harder to formulate a complete strategy for future business.

As an example, let’s imagine that a UK company decided to build a factory in Thailand in 2005 because the cheaper labour here meant that it was more cost-effective to manufacture their product overseas and ship it back to the UK than it was to operate a factory on home soil. Just 15 years later, the relative cost per unit has now skyrocketed, not only because shipping costs have increased (thanks to the increase in pirate activity around the Horn of Africa), but more significantly because of the strengthening baht and weakening pound. That company now has an extremely expensive asset in Thailand (the factory) and their profits are significantly lower than they had envisioned them to be 15 years earlier.

It’s not only the company’s own actions that can be affected by economic exposure. They may have competitors who also import the same product, but do so from countries where the change in exchange rates has worked in their favor and where the native currency has weakened relative to the pound. For them, their cost per unit is decreasing, enabling them to reduce the cost for the customer without impacting their profits and therefore allowing them to undercut the company that invested in Thailand, further harming their earnings.

How can you mitigate foreign exchange risks?

The first question to ask when you are considering the risks outlined above is no necessarily how to mitigate them, but whether or not you want to even try. There are some companies that accept these risks as an inevitable cost of doing business overseas. This is especially true of very large multinational corporations where the profits made are sufficiently high to absorb whatever losses are incurred as a result of currency fluctuations. Even the example given to explain transaction exposure - a loss of 50,000 baht - may be pocket change to such a company and not worth significant investment in measures to minimize such losses.

For those companies that do not operate on such a scale - which is likely to be the vast majority - we have a selection of ways in which to reduce foreign exchange risks. They range from the simple and cheap to the expensive and complex.

Only conduct transactions in your own currency

The simplest way of avoiding any foreign exchange risks is simply to not conduct any foreign exchanges. This is simplest for a small or medium-sized enterprise based in Thailand, paying all of your taxes, salaries and expenses in Thai baht, though is obviously more of a challenge for larger companies with overseas offices.

Another disadvantage is that you may potentially decrease your capacity to do business with overseas clients by only accepting payment in a single currency. For example, customers wanting top buy your products or services and being required to pay in Thai baht may have difficulty processing their payment. While most major credit card companies can complete such transactions, customers may be reluctant to pay the fees that inevitably come with such payments. On a larger scale, overseas supplies and other companies buying from you who do not have funds available in Thai baht will often be able to find competitor companies who are willing to be more flexible, costing you potential earnings and opportunities.

Similarly, for individuals, minimizing the amount of bills you need to pay overseas or your dependence on income paid in foreign currencies will certainly reduce your foreign exchange risks, but will also reduce your options when it comes to income sources and purchasing opportunities.

Include protection in your contracts

Many really big multinational corporations - including those working in the energy or mining industries - depend on long-term planning and equally long-term contracts, putting them at significant risk of incurring losses from economic exposure. However, they mitigate these losses by incorporating that risk into their contracts. This may include clauses that allow revenue to recovered in the event of the exchange rate deviating to the extent that agreed transactions become more or less valuable than they originally were.

While such clauses are an extremely effective way of reducing currency risk, they require the skills  of highly skilled legal and economic experts to draft and a lot of negotiation to be agreed upon. They will also require regular review to ensure that, once the clause is triggered by an exchange rate change, the losses are swiftly and completely recovered. Activating the clause may result in your company recovering lost revenue, but will inevitably result in a loss for the other party involved, which may sour your business relationship. That being the case, it is not unheard of for business to voluntarily choose not to recoup their losses in order to secure new agreements or extend old ones.

Natural foreign exchange hedging

A natural foreign exchange hedge is when a company balances its earnings and expenses in foreign currencies, thereby reducing the overall exposure. For example, the US company with an office in Thailand we used as an example of translation exposure may look to spend the Thai baht that office earns on supplies from Thailand. Even the company is administered from the US, the Thailand office’s earnings and expenses are all in Thai baht. This reduces the need for converting currency, thereby reducing the risks inherent in doing so.

While this is a highly effective approach for companies operating in many countries around the world, it also adds a significant burden to the finance team, not least because it means keeping balance sheets in multiple currencies in order to track the overall risks and the savings made by buying locally over buying from a single distribution center in a single country.

Forward exchange contracts

A forward exchange contract is one of the more common uses of a hedging arrangement that makes use of an external financial instrument - in this case, a third party like a bank or similar institution.

This type of contract sets a future date on which a business agrees to buy or sell a specified amount of foreign currency. The exchange rate is set on the day the contract is signed, ensuring that the amount of currency purchased is exactly the same amount that has been agreed to. This removes the risk of losses incurred by the businesses through transaction exposure. In fact, it shifts the risk to the bank, who must provide the agreed amount of foreign currency on the set date, regardless of what the exchange rate actually is that day. However, if they are fortunate and the exchange rate turns in their favor, they keep the resulting profits of the exchange.

There are some limitations to this approach, though not many. For starters, these contracts are generally limited to 12 months in duration, though exchanges between major currencies like US dollars and euros can be secured under contracts lasting up to a decade. Additionally, a fee is added by the financial institute for operating such a contract. With a high degree of customization often incorporated into these contracts, those fees tend to be quite expensive.

Currency options

Currency options are a slight variation on a forward exchange contract - effectively, one whereby some of the risk is transferred back to the business conducting the transaction, but with some of the potential reward also returned. It amounts to a small gamble with some of the amount being exchanged.

With currency options, the date specified for the exchange is not the exact date of the exchange, but a deadline by which it must be completed. If the currency exchange rate starts to worsen, the company can choose to activate the option early, making the exchange before the rate gets too bad. They lose the cost of the option premium but retain the value of their exchange, ensuring that they have the foreign currency ready to complete their transaction at the rate they agreed to.

However, if the exchange rate improves, the business can allow the option to hit its deadline. The currency exchange is made at a preferential rate and the company makes a profit on the exchange, minus the cost of the option.

On the downside, this approach requires a lot more monitoring and, more importantly, costs even higher fees than the forward exchange contracts do. Option premiums will vary depending on which currencies are being traded and over what period of time, with more volatile currencies naturally being more and more expensive. As great as the potential benefits are, the costs may put them out of reach of smaller businesses.

Which risk management approach should you use?

Your exact foreign exchange policy will entirely depend on your business’s currency flow - there is no one-size-fits-all solution. Each approach has its benefits and drawbacks and, no matter how much you mitigate the risks, there is always going to be some hazards with doing business overseas. You can choose exactly where you do business with extreme care, use every hedge available and keep as much of your business in the same currency as you can, but the fact is that your money will always lose a little value when it is sent across national borders. The only question is, how much?

In order to keep that amount as low as possible, it is best to have either a first-class in-house finance team or outsource the service to experts in the field of foreign exchange, who can manage your risks for you and keep them to a minimum.

This article is provided to you by DeeMoney. Thailand's money transfer solutions provider licensed by the Bank of Thailand. Interested in transferring money from Thailand to the world? Download the app from Google PlayStore or the Apple Appstore to get started.