Currency risk is an inevitable part of international trade. Exchange rate fluctuations can seriously affect profit margins. In this article, we will examine currency risk management strategies and hedging tools.
What is Currency Risk?
Currency risk is the potential for exchange rate movements to adversely affect a business’s financial position.
Risk Types
1. Transaction Risk
- Currency change risk in existing contracts
- Difference between sales invoice ↔ collection
- Most common and measurable risk type
2. Economic Risk
- Long-term competitiveness impact
- Market share changes
- Affects strategic decisions
3. Translation Risk
- Impact on consolidated financial statements
- Foreign currency assets/liabilities
- Accounting-based
Calculating Risk Exposure
Net Currency Position = Foreign Currency Receivables - Foreign Currency Payables
Example:
EUR Receivables: €500,000
EUR Payables: €200,000
Net Long Position: €300,000
Exchange Rate Change Impact:
If EUR/TRY drops from 36 to 35
Loss: 300,000 × 1 = 300,000 TL
Hedging Strategies
1. Forward Contract
Forward is a commitment to buy/sell currency at a specific rate on a future date.
How It Works:
- Lock in rate today
- Execute transaction at maturity
- Agreed rate applies regardless of market rate
Example:
Today: EUR/TRY = 36.00
3 month forward: EUR/TRY = 36.50
Contract amount: €100,000
On maturity date:
Spot rate: 38.00 → Gain: 150,000 TL
Spot rate: 35.00 → Loss: 150,000 TL
(Transaction at 36.50 in both cases)
Advantages:
- Certain cost/revenue determination
- Budget planning ease
- No premium payment
- Customizable maturity and amount
Disadvantages:
- Cannot benefit if rate moves favorably
- Collateral requirement
- Mandatory fulfillment
2. Currency Options
Options provide the right (not obligation) to transact at a specific rate.
Option Types:
| Type | Right | Usage |
|---|---|---|
| Call | Right to buy currency | Importer |
| Put | Right to sell currency | Exporter |
Example (Exporter - Put Option):
Today: EUR/TRY = 36.00
Put option strike: 35.50
Premium: 2% (€2,000 for €100,000)
Maturity: 3 months
Scenarios:
Spot = 34.00 → Exercise option (35.50)
Spot = 37.00 → Let option expire (sell at spot)
Advantages:
- Benefit from favorable rate movement
- Limited maximum loss (premium)
- Flexibility
Disadvantages:
- Premium cost
- Complex structure
- Accessibility
3. Currency Swap
Exchange of cash flows in different currencies between two parties.
Usage Areas:
- Long-term financing
- Gaining interest advantage
- Balance sheet management
4. Natural Hedging
Balancing currency position through operational arrangements.
Strategies:
a) Income-Expense Matching
EUR income: €100,000/month
EUR expense: €80,000/month
Net open position: €20,000/month (only hedge this amount)
b) Currency Borrowing
- Export revenue EUR → Use EUR loan
- Natural matching achieved
c) Pricing Strategy
- Price in foreign currency
- Transfer currency risk to customer
d) Supply Restructuring
- Purchase inputs from export market
- Geographic balancing
5. Invoice Currency Selection
Strong Currency Strategy:
- Strong currency for exports (EUR, USD)
- Weak currency for imports (TL)
Local Currency Strategy:
- TL agreement with suppliers
- Transfer of currency risk
Implementation Guide
Step 1: Risk Identification
Position Mapping:
- List all foreign currency receivables
- List all foreign currency payables
- Group by maturity
- Calculate net position
Example Risk Map:
| Maturity | EUR Receivable | EUR Payable | Net Position |
|---|---|---|---|
| 30 days | €50,000 | €30,000 | +€20,000 |
| 60 days | €80,000 | €20,000 | +€60,000 |
| 90 days | €100,000 | €50,000 | +€50,000 |
| Total | €230,000 | €100,000 | +€130,000 |
Step 2: Risk Measurement
Value at Risk (VaR) Approach:
VaR = Position × Volatility × Z-score × √Maturity
Example:
Position: €100,000
30-day volatility: 5%
95% confidence level (Z=1.65)
VaR = 100,000 × 0.05 × 1.65 = €8,250
TL equivalent: ~300,000 TL maximum loss
Step 3: Strategy Determination
Hedging Ratio Decision:
| Risk Tolerance | Hedging Ratio |
|---|---|
| Very low | 100% |
| Low | 75-90% |
| Medium | 50-75% |
| High | 25-50% |
| Speculative | 0-25% |
Factors:
- Profit margin size
- Cash flow importance
- Market view
- Cost tolerance
Step 4: Tool Selection
Decision Matrix:
| Situation | Recommended Tool |
|---|---|
| Certain receivable/payable | Forward |
| Uncertain amount | Option |
| Regular cash flow | Natural hedging |
| Long maturity | Swap |
Step 5: Implementation and Monitoring
Checklist:
- Position currency
- Hedge maturity fit
- Effectiveness evaluation
- Cost tracking
- Policy compliance
Creating Hedging Policy
Policy Elements
1. Objectives
- Profit margin protection
- Cash flow stability
- Budget deviation minimization
2. Scope
- Which risks to hedge
- Which currencies included
- Minimum transaction amount
3. Tools
- Permitted instruments
- Prohibited transactions
- Counterparty limits
4. Ratios
- Minimum hedging ratio
- Maximum hedging ratio
- Maturity limits
5. Authority and Control
- Decision authorities
- Approval processes
- Reporting requirements
Sample Policy Summary
CURRENCY RISK MANAGEMENT POLICY
Goal: Hedge 70-90% of net currency position
Permitted Tools:
- Forward contracts (max. 12 month maturity)
- Vanilla options (max. 6 month maturity)
Prohibited Transactions:
- Speculative positions
- Exotic derivatives
- Leveraged transactions
Authority Limits:
- Up to $100,000: Finance Manager
- Up to $500,000: CFO
- Over $500,000: Board of Directors
Reporting:
- Weekly position report
- Monthly hedge effectiveness report
- Quarterly strategy evaluation
Common Mistakes
1. Over-Hedging
- Hedging more than actual risk
- Non-realization risk
- Cost increase
2. Under-Hedging
- Insufficient protection
- Unexpected losses
- Budget deviations
3. Neglecting Hedge Accounting
- IFRS 9 non-compliance
- P&L volatility
- Audit issues
4. Counterparty Risk
- Dependency on single bank
- Collateral insufficiency
- Limit excess
5. Timing Errors
- Hedging too early
- Hedging too late
- Maturity mismatch
Conclusion
Currency risk management is a critical component of foreign trade. A proactive and systematic approach minimizes the negative effects of exchange rate fluctuations and protects business value.
As Gökçe Trade, we provide currency risk consultancy in your foreign trade operations. We are with you with structuring recommendations to reduce currency risk in your supply and sales processes.
Contact us for currency risk management.