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What are the main FX risk types and FX risk metrics used to measure them?

by Darryl Hood | June 7, 2018

What are the best metrics for managing FX risk?

A successful FX risk management strategy needs to include FX risk measurement. Let’s take a look at some of the metrics that are commonly put in place…

No matter what size your business, foreign exchange (FX) risk can be a challenge. In fact, Deloitte’s Global Corporate Treasury Survey 2017¹ highlighted the two biggest challenges for treasurers as FX volatility and visibility of and access to group cash, operations and exposures.

So let’s take a closer look at the different types of FX risk and how to measure them. Once you have a clear picture of FX risk types you can make a robust FX risk management plan, which may involve making internal changes and/or implementing strategies such as hedging.

The types of FX risk

There are two main types of risk when it comes to FX exposure:

  1. Transaction exposure

Transaction exposure is the simplest form of FX exposure to measure and manage. It is usually associated with imports and exports and happens when a business makes or receives payments in a foreign currency. The risk occurs when the exchange rate changes between the date of the business transaction and the settlement of the payment. The level of risk depends on the size of the transaction, the amount of time that the cash flow is affected and the resulting exchange rate movements over the time frame.

  1. Translation exposure

This happens when a company has assets in another currency and has to translate them for the purposes of accounting and reporting. If there are changes to the exchange rate this can affect the value of the company’s assets and must be reported.

Check out why AI may be the future of FX hedging for treasurers in our blog>

How AI will transform corporate hedging for treasurers

FX risk metrics at a glance

How are you currently monitoring and managing FX risk? In the Deloitte 2017 survey¹ only 25% of corporates surveyed were monitoring risk measures, and 45% of respondents weren’t actively monitoring FX risk at all – which is surprising bearing in mind the challenges many are facing.

Before you formulate a FX risk management strategy, you need to understand how to measure FX risk. There are a number of ways to do this, with the most common tools being:

  • Value-At-Risk (VaR)

Value at risk (VaR) is an estimate of how much a company’s investments might lose or gain under normal currency market conditions over a set time period.

  • Cash-Flow-At-Risk (CFaR)

Cash-Flow-At-Risk (CFaR) estimates how a company’s future cash flows may change over a set time period as a result of FX market changes.

  • Earnings-At-Risk (EaR)

Earnings-At-Risk (EaR) estimates how much income may change over a set period. It is based on previous earning figures; the longer the period of time analysed, the higher the FX risk.

A robust FX risk management strategy

Now you have a clearer understanding of the different FX risk types and metrics you can start putting KPIs in place. With a robust strategy you can be confident your FX risk is being managed on a day-to-day basis. Once you start tracking performance against your KPIs, you can make more informed decisions about which FX risks need managing, and with which tools.

For more useful information on foreign currency and FX risk

To talk to us about which FX risk management metrics may work best for your company, get in touch.

References

  1. Deloitte’s Global Corporate Treasury Survey 2017

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