Currency Risk Management For Irish SMEs - DETE

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Currency RiskManagementFor Irish SMEsDeveloped bythe Department of Business,Enterprise & Innovation

Currency RiskManagementThe recent financial crisis, US elections and political uncertainty aroundBrexit has set a backdrop of a more competitive and unpredictable businessenvironment, one in which firms of all sizes have recognised the importanceof financial risk management as a key component of protecting their earnings,profits and working capital.In particular, companies with exposure to foreign currencies are prioritisingand developing their hedging strategies, allowing them to respond moreeffectively to the challenges of this unpredictable landscape.Whilst large companies have recognised the importance of this issue, manysmaller companies are lagging behind. Recent research by Bord Bia in Irelandsuggests that while 50% of businesses impacted by Brexit do have a currencyhedging strategy, the figure is significantly lower for firms with turnover of lessthan 10m.Currency movements can be sudden and large, as we saw with sterling in thewake of the Brexit referendum. If your business has a material exposure toa non-euro currency you need to be aware that if you do not have a hedgingstrategy you are taking a gamble with your bottom line.The guidance that follows will seek to answer many of the questions thatIrish SMEs may have when assessing and managing their exposure to foreigncurrency risk, set out in sections dealing with: the importance of currencyrisk management; how to assess currency exposure and develop a currencymanagement strategy; practical guidance for companies that have notpreviously engaged in currency management; and a directory of supportservices and providers that are available in the market.Whilst the focus of this guidance will primarily be with respect to sterlingrelated currency risk, the principles can equally be applied to Irish SMEsimporting goods from or exporting goods to any non-euro country or market.My Department, offices and agencies are always available to advise andsupport businesses. I hope you find it useful.Heather Humphreys TDMinister for Business, Enterprise and Innovation.

1The importance of currency riskmanagement for Irish importersand exportersWhy should Irish SMEs actively managetheir currency exposures?With the UK scheduled to leave the European Union on31 October 2019, continued uncertainty on the prospects for aBrexit deal is causing volatility on currency markets, particularlywith the euro/sterling exchange rate. Weak sterling is a majorconcern for Irish exporters to the UK.Since the Brexit vote, the valueof sterling has depreciatedapproximately 13% against theeuro and is expected to remainvolatile as political and economicuncertainties continue. Similarlevels of volatility have beenobserved in the euro/US dollar rate.EUR GBP1.4501.3501.2501.1501.050OCT 2015Difficulties stem not only from thetransaction exposure of translating sterlingsales at a weaker rate but also due toreduced competitiveness against nowcheaper local UK alternatives.OCT 2018

But there has been some good news.There are some Irish industries relying on UK imports that haveexperienced a “Brexit boom” as euro equivalent prices have fallen inline with weakening sterling (e.g. the construction and automotiveindustries). The contrasting fortunes of the Irish exporters andimporters highlights that the impact of currency exposures, and themanagement thereof, needs to be carefully considered, and the decisionto hedge (or not) is dependent on a number of factors including thecompany’s risk appetite, contractual commitments, payment cycles andunderlying business margins. Businesses also need to assess how theymay have natural hedges, for example exporters may have inputs fromsterling area which have reduced and offset some of the loss of pricecompetitiveness on the output side.Benefits of HedgingProtect yourbusiness fromfinancial shocksMakefuture cashflows morepredictableImprove yourfinancialflexibilitythrough prudentrisk policy

2How to assess currency exposureAm I exposed to currency risk if Iexport to non-euro markets in thelocal currency?Yes, this is because of the time lagbetween when a contract denominatedin a foreign currency is agreed, andwhen it is ultimately settled/paid. Thisexposure also relates to transactions inthe near future that have not yet beenexecuted.I also export to non-euro marketsbut in euro, do I have an exposurehere too?Yes, you may be running an exposuredue to reduced affordability andcompetitiveness against what are nowcheaper local market alternatives.What about if I have a branch orsubsidiary in non-euro markets?If you have a branch or subsidiaryoperating in a non-euro currency areayou may also be running a financialstatement exposure. This couldcause problems for you because theretranslation of foreign currency assetsand liabilities may affect balancesheet measures and ratios, which cannegatively impact any debt covenants.Maybe I should wait and takemy chances?That would be a gamble. Currencymovements can be large and sudden.With no hedge in place you mayexperience unpredictable swingsin cash flows and margins. It is onlythrough fixing the rate that certaintycan be achieved with respect tomargins and profits, as the euroamount of foreign currency cash flowsbecome predictable.How do I know if the risk is material?The size of your exposure can beestimated by identifying the extent towhich any foreign currency revenuesare not offset by costs in the sameforeign currency.For example, if you are selling 10mof product to the UK in sterling butalso incur 7m of sterling denominatedexpenses then your net exposure tovolatility in the sterling exchange rateis 3m sterling. A 10% depreciationin sterling against the euro wouldtranslate to an approximately 300,000euro loss at this exposure level.

3How to develop a currencymanagement strategyWhat should I do if I want to manage my exposure?Talk to your bank who will advise you about using derivative products forhedging purposes. The use of such products should be considered in thecontext of their cost and flexibility.Financial hedging products fall broadly into two types,each with their pros and cons:(i) Products that fix the exchange rateForward foreign exchange contracts are a low-cost product, with no upfrontpayment, that may be used to fix the exchange rate on expected foreigncurrency receipts or payments. As the rate is ‘locked in’, however, you willhave no flexibility if exchange rates move in your favour.Cross currency swaps can also be used to fix the exchange rate on foreigncurrency funding cash flows. Companies enter into cross currency swapsto hedge long-term borrowing commitments dominated in a foreigncurrency.(ii) Products that allow rate flexibilityYour bank may also be able to provide currency option contracts. Thisallows rate flexibility thus avoiding a potential opportunity loss fromfavourable exchange rate movements whilst also providing protection inthe event of unfavourable movements. This flexibility may come at someadditional cost depending on the level of exposure you wish to take.Currency options can also be useful for hedging a contingent exposure.For example, if you are tendering for a project whose revenue flows willbe in a foreign currency you could use currency options to hedge thepotential exposure, knowing that if you don’t win the tender you don’thave to exercise the currency option.What about in the longer term?In the medium to long run it may be more effective to consider moving yourfocus to new markets with lower or no currency transaction risk for example,shifting the sales drive from UK to EU markets.

4Practical Guidance for thosenew to currency managementHow do I put a hedging contract in place?If you are an SME, the easiest way to begin accessing the hedging marketwill be through existing banking relationships. Other product providersmay be available but you should be comfortable that you are transactingwith a reputable and regulated institution.Discuss your foreign currency risks with your local bank relationshipmanager who will refer you to the relevant contact in the bank’s TreasuryDealing Room, providing you with an overview of foreign exchangehedging products. They will explain the available options appropriate toyour company.If you wish to proceed with putting a hedging strategy in place you canengage with your bank’s Treasury Dealing Room about the particularparameters of the hedging product(s) that you require and obtainindicative price quotes. You will receive correspondence from the bank toconfirm any trade agreed, and also prior to the maturity date to confirmthe settlement terms. This may involve some regulatory reportingrequirements, but your bank will assist you with this.Is it difficult and time consuming?No, your bank will guide you through the setup process, which they willhave done for many other customers like you.

5Directory of SupportServices and ProvidersForeign Exchange Product ProvidersRegulatory & Government AgenciesFor example, banks and investmenthousesCentral Bank of Data ProvidersDepartment of Business, Enterpriseand markets/currenciesEnterprise Irelandwww.prepareforbrexit.comReutersEnterprise Ireland Currency enciesFTID en/UK-Export-Help/Sterling-impactcalculatorBord Biawww.bordbia.ieIndustry bodiesIrish Association of CorporateTreasurerswww.treasurers.ieReference / MediaThe Global Management

6GlossaryContract RateDerivativean agreed exchange rate at whichthe currency pair will be exchanged.The Contract Rate will always be lessfavourable than the Forward ExchangeRate available to you at the time.a financial contract which derives itsvalue from the performance of anunderlying asset or value such as aninterest rate or currency exchange rate.Currency Optiona contract that gives the buyer the right,but not the obligation, to buy (call) or sell(put) a certain currency at a specifiedexchange rate on or before a specifieddate. Should the real market price of thecurrency be lower than that outlinedin the call option (or higher than thatoutlined in the put option), the holder ofthe contract can go to the market insteadand simply pay the premium for holdingthe contract.In its most simple form a currency optionacts like an insurance policy. In returnfor paying an up-front premium theoption contract limits downside riskby locking in the strike price, but alsoallowing companies to benefit fromfavourable exchange rate movements.More complex or structured optioncontracts may have a reduced or zeroupfront premium, but will involve a lessfavourable potential payoff profile whencompared to the simple version.Cross Currency Swapan agreement in which two partiesexchange the principal amount of a loanand the interest in one currency forthe principal and interest in anothercurrency. Companies enter into currencyswaps to hedge a long-term borrowingcommitment denominated in a foreigncurrency.Forward Foreign Exchange Contracta contract agreed upon by two entitiesto buy or sell a certain amount of acurrency at a set rate of exchange at afuture date.Forward Exchange Ratethe price of one currency in terms ofanother currency for delivery on aspecified date in the future. This is therate the bank would make available toyou at the relevant time.Maturity Datethe date set out in the tradeconfirmation. It is the date on whichthe outcome of the contract will bedetermined.Strike Pricean agreed exchange rate which is usedas a reference point when determiningwhether the option will be exercised. It isthe exchange rate at which the currencypair will be exchanged when the option isexercised.Trade Confirmationa document issued to you by your bankfollowing the agreement of the trade.Developed in association with PwC.

interest rate or currency exchange rate. Forward Foreign Exchange Contract a contract agreed upon by two entities to buy or sell a certain amount of a currency at a set rate of exchange at a future date. Forward Exchange Rate the price of one currency in terms of another currency for delivery on a specified date in the future. This is the

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