Minimizing the risk of foreign currency transactions

Financial Knowledge

Foreign currency transactions - Minimizing risk

Even SMEs can lower interest, currency and commodity management risks. Important is the right strategy based on an end-to-end financial analysis.

The German economy is booming. One of the main reasons is that local companies are doing business with customers from around the world. In July 2017, the German Federal Statistical Office announced that goods with a value of EUR 110.6bn were exported in May 2017, while imports amounted to EUR 88.6bn. This represented a year-on-year increase of 14 percent and 16 percent respectively.

Different reasons for foreign currency transactions

According to the Association of German Chambers of Commerce and Industry, German companies invoice more than 43 percent of their business with customers outside Germany in foreign currency – and this figure is rising slightly. There are many different reasons for this:

  • Certain transactions are always concluded in the same currency, e.g. commodities transactions (gold, oil, etc.) in US dollars.
  • Partners may agree on one currency to make processing easier for both parties, or because this is desired by the partner with the stronger negotiating position.
  • Some foreign companies are unable to invoice in euros due to the foreign exchange regulations in their country or may have no access to the German market for other reasons.
  • Invoicing in foreign currency is a sign of trust and can improve a company's position in price negotiations. For example, invoicing in renminbi can lead to significant price advantages for the parties involved.
  • Invoicing in the currency of the respective contractual partner can constitute a competitive advantage compared with other German and international providers, and hence help to support local acquisition.

Risk of loss due to exchange rate fluctuations

The purchase price is typically paid when the goods are delivered. A company selling a machine to the United Kingdom at a price of GBP 100,000 today cannot know for sure what the exchange rate will be when the corresponding revenue is recognized on delivery in six months' time – not least thanks to Brexit and its consequences. Even before Brexit, though, the GBP exchange rate was subject to considerable fluctuation. Over the past ten years, the British currency has fallen by around 23 percent against the euro. However, this development was far from uniform (see slider chart with information on the development of selected other currencies).

  • EUR-GBP exchange rate, 2000-2017. The United Kingdom was Germany's fifth-largest trading partner in 2016.

    Overview: EUR-GBP exchange rate

    With an import and export volume of around EUR 121bn, the United Kingdom was Germany's fifth-largest trading partner in 2016.

  • EUR-USD exchange rate, 2000-2017. The USA was Germany's third-largest trading partner in 2016.

    Overview: EUR-USD exchange rate

    The USA was Germany's third-largest trading partner in 2016 with an import and export volume of around EUR 165bn.

  • EUR-CHF exchange rate, 2000-2017. Switzerland was Germany's ninth-largest trading partner in 2016.

    Overview: EUR-CHF exchange rate

    With imports and exports totaling around EUR 94bn, Switzerland was Germany's ninth-largest trading partner in 2016.

  • EUR-CNY exchange rate, 2000-2017. China became Germany's largest trading partner for the first time in 2016.

    Overview: EUR-CNY exchange rate

    China became Germany's largest trading partner for the first time in 2016. The volume of imports and exports with China amounted to just under EUR 170bn.

The current exchange rate is around GBP/EUR 0.88755 (as of May 2017). Based on this rate, the exporter in the above example would recognize revenue of around EUR 112,670 for the machine. If the exchange rate were to weaken to GBP/EUR 0.96 by the time the machine is delivered, however, the exporter would recognize just EUR 104,167 – a loss of more than 7.5 percent.

Managing currency risk through end-to-end financial analysis

SMEs often underestimate this risk. Forecasts of future exchange rate movements are often "too casual", says Frank Schmidt, authorized officer for Interest/Currencies/Commodities Solutions at LBBW. "The exchange rate applied by companies in their projections often fails to reflect reality. Significant deviations can lead to losses. But this is not an inevitability. Currency risk can be managed," Schmidt adds. LBBW's experts develop tailored strategies for corporate clients.

"Above all, LBBW seeks to offer clients more than just simple hedging products to reduce their currency risk. What we provide is end-to-end financial analysis. We intensively address a company's key performance indicators (KPI). To ensure that the entire process does not become overloaded and the cost for the client remains reasonable, we limit ourselves to the KPIs that are central to currency risk," Schmidt explains, adding that the aim is to come up with a recommendation for the optimal hedging ratio based on transparent steps and then compile a suitable set of tools and instruments in conjunction with LBBW's derivative specialists.

Risk volume and loss potential analysis

Firstly, all of the company's foreign exchange activities are added up. This gives the risk volume, which forms the basis for loss potential analysis. This analysis is based on the cash flow at risk (CFaR) model. The aim is to answer the following questions:

  • What is the maximum loss from foreign exchange transactions?
  • What risk of loss is the company willing/able to bear?
  • To what extent is it necessary to hedge this risk in order to prevent a significant downturn in the company's KPIs?
  • To what extent will hedging reduce the risk of loss, e.g. with regard to return on equity?

In simple terms, the analysis involves using past exchange rates and forecasts of future exchange rate development (e.g. based on prices on the futures markets) to simulate the potential exchange rate movements for a certain risk position compared with the company's forecasts. The probability of these deviations is also calculated. Finally, LBBW's experts calculate the impact of unfavorable exchange rate developments on the client's KPIs (loss potential) and what the company's risk-bearing capacity is. All of this results in a recommended hedging ratio.

Schmidt: "Our experience shows that a tailored hedging strategy can significantly reduce currency risk. This can help companies, including SMEs, to better leverage the benefits of invoicing in a foreign currency".