For most businesses that have an FX Hedging program, the two most common forms of FX risk are transaction risk and translation risk
Transaction risk will arise from a business transaction that generates a foreign exchange cash flow. For example, an Australian business that buys inventory from a UK supplier will have an exposure to the AUD/GBP cross rate. In this case the business will likely create a forecast for this cash flow during the budgeting process and calculate the potential exposure in AUD using a budget rate. However, it is not until the order has been confirmed that the exposure becomes committed. Between when the order is committed and when the business is required to make the payment, the result is an uncertain AUD value.
Translation risk will arise when a business has cash or other balance sheet items denominated in a foreign currency. They could be cash balances from a subsidiary company, or the proceeds of sale of an overseas asset. These assets are required to be revalued in to the businesses base currency and in doing so create changes in equity.
Translation risk could also come in the form of earnings overseas and these inflows represent risk in the same way that a supplier payment would except that the cash can be pooled (if small invoice amounts) and translation can be deferred in favour of a more favourable rate.
Hedging uncertain transactions
In reality the certainty of the cash flow and the timing can be significantly different than what was first budgeted for. This can be the case for both transactions and translation risk. Further the degree of uncertainty will tend to be greater the longer the forecast is in to the future and therefore common practice tends to be a rolling approach to hedging forecasts using time buckets or hedge coverage ratios.
We have a more detailed explanation Hedge Coverage Ratios but using the example above, the business that forecasts 1m GBP purchases from their supplier in their UK each month may decide to hedge 100% of their forecasts 0-3 months, 75% for 3-6 months and 50% for 6-12 months.
Finally one of the key ways for businesses to minimise their exposure is to use natural hedging wherever possible. Natural hedging or netting FX exposures is the most effective form of hedging because it not only allows businesses to reduce the margin taken by banks when exchanging currencies but it is simple to understand.
However it does require a systematic approach and a relatively real time view of their exposure and a mechanism or platform to perform the netting. Combining that with the uncertainty of foreign cash flow makes the process more difficult and having foreign currency accounts is a practical way of helping in the process.
Therefore for businesses that have both inflows and outflows in the same currency, calculating the net of these two flows and using foreign currency account balances to pay a portion or all of the exposure is an effective strategy and reduces translation risk. Hedging translation risk is often reared as net investment hedging because the net balance sheet position is hedged rather than the individual cash flows.