With a daily equity volume of $5.1 trillion, the foreign exchange market is by far the largest financial market in the world. And even during the best economic times, unforeseen activity in the forex market can cause currency fluctuations that have huge impacts on global business.
Unfortunately, there’s no way to predict the future when it comes to currency movements. However, with proper planning and risk management, you can minimize the impact sudden currency swings have on your business.
Keep reading for more tips for dealing with currency fluctuations.
Understanding the impact of currency fluctuations
It’s easy for businesses to neglect to take currency into account in their financial plans, especially during times of growth and profitability. But the recent effects of COVID-19 on the forex market and countless other aspects of the global economy have put currency risk back on the planning map for many organizations.
Unforeseeable events like COVID-19 can have dramatic effects on currency markets. So far, we’ve seen the coronavirus affect global currency and financial markets in 3 main ways:
- Driving down demand and supply. Travel restrictions and quarantines have hammered the global economy into a fraction of its normal activity, driving down demand on all fronts and crippling the supply chains that make the world go round.
- Straining financial safety. Liquidity and cash flow around the world are down, causing shock waves through financial markets and threatening businesses of all sizes.
- Extreme forex instability. Currency markets have been extremely volatile since late February.
In today’s globalized world, almost every business is affected by currency fluctuations and exchange rates, which can impact a company’s assets, liabilities, and cash flow.
Unfortunately, there’s no way to predict exchange rates or the events that might impact them. Uncertainty is the only certainty when it comes to financial planning.
Accepting this uncertainty is the first key step in preparing your company for the future. Once you realize that there is no crystal ball, you and your finance team can start adopting new planning processes that focus on preparing your business for the potential scenarios up ahead, rather than trying to predict the unpredictable.
Using Scenario Planning and Probability Analysis to measure and plan for currency risks
Scenario Planning has gotten a lot of mentions in our blog posts and webinars lately, and for good reason. In these uncertain economic times, Scenario Planning is the best way to plan for the future. More specifically, Scenario Planning is particularly effective at preparing for currency fluctuations.
“In managing currency exposures, you’ve got to take a step back,” says John Power, Director of Strategic Growth Leaders, in an interview for EnterpriseIrelandTV. “You’ve got to understand the nature of the exposures, the extent of your exposures, and the duration of those exposures before you can begin managing currency fluctuations.”
This is where Scenario Planning and Probability Analysis come into play. Unlike trend analysis, one of the pillars of traditional financial planning, Scenario Planning and Probability Analysis don’t base future projections on past trends. Instead, they encourage us to think of different scenarios or possible future outcomes and analyze their impact on our key business drivers.
When it comes to currency fluctuations, for example, a Scenario Analysis would look at the key currencies affecting your business and 3-7 ways in which those currencies might fluctuate in the coming 3, 6, or 12 months (including best and worst-case scenarios).
For each of these scenarios, you’ll want to put together a detailed analysis of how their outcomes will affect the key drivers of your business. Could a currency spike in your manufacturing countries drive up your production and shipping costs? Will currency drops in your biggest sales markets drive down your profit margins? How will these fluctuations affect your cash flow, asset values, debt, etc?
Use Event Trees to create action plans based on your Scenario Analysis
Once you’ve listed your scenarios and their impact on your key drivers, you’ll want to start putting together a clear action plan for each possible scenario. Besides outlining clear steps for dealing with a particular fluctuation, you’ll also want to list trigger events that will set these plans into motion. Event Trees can help you visualize the effects of certain events and put together more solidified action plans in response to your Scenario Analysis.
Exactly how your company plans to deal with a particular scenario will vary based on its drivers and the kinds of currency risks its facing. Hedging is obviously a common method companies use to mitigate their foreign exchange risks, but it’s not a decision that your executive team can or should make at the drop of a hat. By closely analyzing your currency risks early, you might be able to identify other solutions that are better suited to your business and its needs.
As a financial planner, you can’t be asked to predict forex shocks, global pandemics, recessions, political movements, or any other phenomenon that might impact something as volatile as global currency rates.
You can, however, help your organization accept the uncertainty it is facing and prepare for it accordingly. For more insight into leading FP&A methods like Scenario Planning, Probability Analysis, Event Trees, and more, check out our webinar on FP&A Best Practices here.