FX Management: A Practical Basic Understanding
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As financial executives, it is crucial that we at least understand:
- The reasons for managing foreign exchange (FX),
- The types of foreign exchange exposure that we are faced with,
- Some common terms used in foreign exchange dealing,
- Some simple rules we should follow when transacting FX with FX dealers,
Why do we need to manage FX? Some reasons are:
- With proper FX management, a company’s competitive position and shareholder value can be protected,
- It can help reduce the negative effects of radical exchange rate movements on financial results,
- Improve strategic decisions
Do we understand what types of FX exposure a company may be faced with? Basically, there are three (3) type of FX exposures:
- Transaction exposure: Arises as a result of cross border trading.
- Translation exposure: Arises from the need for period revaluation of a company’s assets and liabilities, as well as income and expenditure streams denominated in a foreign currency. This normally takes place on consolidation of the accounts of foreign subsidiaries.
- Economic exposure: Arises from a company’s commitment to specific currencies and currency environments. For example, if our Singapore-based company’s main market was Malaysia, then over the past year our products may have been facing stiff competition from similar Malaysian made products simply because the SGD was appreciating against the Malaysian Ringgit. Hence, we are compelled to cut our SGD prices in order to retain our market share in line with the new exchange rates. It can also arise even if we are dealing exclusively with the domestic market. This could be due to foreign competitors being from countries which currencies are depreciating against the SGD, and as a result, their goods are now more competitve against ours.
Two (2) Common Terms Used in foreign exchange (FX) dealing:
- Value Spot, Value Tom or Value dd/mm/yy: Value spot means requiring settlement TWO(2) business days after the date of the transaction. Value Tom is the “next-day” settlement, while Value dd/mm/yy means a specific date to make settlement. It is very important for financial executives to understand the above-said terms as we must ensure that the company has sufficient funds as and when the settlement falls due.
- Fixed/Outright Forward Contract and Forward Time Options Contract: In the case of a Fixed Forward Contract, we agree with a bank on an exchange rate for the delivery of a particular currency against another at a FIXED future date. As for a Forward Time Option, we can take delivery WITHIN A CERTAIN future period instead of a particular date. Both contracts can be used for hedging purposes, namely we are locking in a company’s FX profit or costs and eliminating future gains by fixing our costs or losses.
Other terms like currency swaps and currency futures are not included in this basic coverage of FX.
With the basic knowledge above, we will next need to understand the simple rules when transacting with our FX dealers from our company’s bankers: If we are asking/transacting for FX rates, be sure that we are clear to the FX dealer on:
- the foreign currency involved with special emphasis on whether we are buying or selling and what currency involves,
- after getting the rate, repeat the quantity of currency involved and emphasise its equivalent value in the other currency. This acts as a double check after finalizing a deal. If you forget, the dealer should repeat the deal. (P.S.: the conversation of the deal should be taped for future reference)
We have now finished with the first part of a series of articles on the basics of Foreign Exchange Management. In future articles, we shall look further into the various types of internal hedging approaches available to us.
- Foreign Exchange Management: Internal Hedging Method (Part 4 of 4)
- Commonly Used Terms In Foreign Exchange
- Foreign Exchange Management: Before Even We Consider Hedging Strategy
- Foreign Exchange Strategies : Managing FX/Foreign Exchange Transaction Exposure Risk
- Foreign Exchange Management: Performance Management
- Foreign Exchange Management: Forecasting and Quantifying FX Currency Risk
- Foreign Exchange Strategies: Operation/Management Policy And Procedures
March 28, 2006
Posted in: Forex Management
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