Of all the financial priorities for an operating business, currency risk management is often lower down on the list. It is true that, in the long run, much of the volatility in major currencies does even out, and trade tends to fall within ranges of approximate 'fair value'. Although the valuation of major currencies is an intriguing topic, we're focussing today on the tangible tactics operating businesses can implement to take a more savvy approach to currency management. Here are three of our most sizzling strategies to reduce your risks and hopefully boost that bottom line in 2023.

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Note: Please keep in mind that we may receive a commission when you click on our links and make a purchase or sign up for a service. This, however, has no bearing on our recommendations, reviews or comparisons.

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#1 Go Beyond the "Default" Method of Tracking Foreign Exchange Gains/Losses (AKA: What gets measured, gets improved!)

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How would we know when a business has missed out on best pricing for foreign exchange pricing? This is a good question! Before we unpack this in detail, let's look at what is actually happening on the currency markets every day of your trading operations.

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1. Currency markets are always changing during every trading day on the markets. Xero updates its daily spot rates from XE.com, Quickbooks uses IHS Markit / S&P Global, and Zoho Books uses Open Exchange Rates. These sources of global spot rates are all well and good, and are useful in the calculation of your currency gain/losses line item on your income statement. In your accounting software, this currency gain/loss account is a 'system' account and you are not permitted to modify it or alter the way in which transactions are booked to this account. Note also that spot rates at any particular time are the rates that apply at the most recently transacted bid/ask price, and typically involve extremely large volumes between institutional buyers and sellers. As we move from institutional large volume players to large commercial transactions booked via capital markets traders and then down to retail everyday family and small business transactions, increased currency spreads are common. A spread is a commission that the intermediary such as a bank, credit union or payment gateway takes in order to complete the transaction. As we will see, the choice of intermediary can make an enormous difference over time.
2. The booking rate you receive as a 'default' from your accounting software from these websites is virtually always different from the actual booked rate. Your software will book transactions as if you had access to the best spot rates on the planet. Regardless, most of the time, it's fine to have this operating assumption for our daily operations. If our base currency is CAD, and we receive customer payments in USD, we generally won't be concerned about the booked spot rate conversion in our base currency that occurs with each sale. We don't always have control over the precise timing of each customer payment or expense and it would be prohibitively expensive and wasteful to attempt to time transactions to magnify gains or minimize losses. This is not to suggest that we shouldn't exercise care with large, future dated currency transactions where we might attempt to reduce the risk from an unfavourable swing in currency rates (a topic for another day!).
3. However, many businesses aggregate relatively large amounts of payments or cash and then complete a currency exchange transaction. It is *these* transactions that are at risk of being booked via a high-cost intermediary, such as a traditional financial institution. Essentially, we have control over how large of a spread we pay. If we book through a high cost intermediary, we can expect a high spread and a larger gain/loss discrepancy from the spot rate. If we book through a low-cost intermediary, we might be surprised how close we can get to the spot rate.

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Here's a real world example: 

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Our recommended currency exchange partner is Wise.

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So, to recap here there are two steps that should be implemented: 

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1) Have a bookkeeping function that involves a detailed look at 'best pricing' execution for larger currency excchange transactions. Did the business achieve something close to best pricing on its trades? If not, can we verify the scale of the foregone savings and book this as a categorized expense? If we can, let's ensure that that is done. By doing so, we can migrate some expenses in what would otherwise be generic currency gains/losses and assign them to specific vendors and a new expense account. We can call this account "Excess Currency Spreads" or something similar. With each transaction booked in this fashion, we are creating visibility about the precise value we would have received had we achieved best pricing, *and* the scale of the foregone savings we have forfeited to the lower cost provider (this would be the expense that will show up on the account reconciliation).  Any remaining difference between the best-execution rate and the spot rate is booked, as usual, to the system account for FX gains/losses. As a result of this additional work to hunt down the hidden fees of FX spreads, any user of the financial statements can review the months transactions and note that there is a large expense! In our example, $870 CAD in 'Excess Currency Spreads' will get the attention of many business owners. Is $870 in savings on just a single transaction worth opening up a low-cost alternative such as a Wise account? We would hope that in many cases, it would be.

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One transaction of $870 may not move the needle for some businesses. It is key to focus management's attention on the big picture. What are the costs of not seeking best pricing each month, quarter, or year. Managers and executives are busy people. Unless they see something that is tangible and evidence of a problem, they are unlikely to correct it. Tracking foregone expenses in this way can be a valuable way to bring oversight to currency exchanges, and to move them on to a lower-cost platform for those higher dollar value transactions (such as Wise). We have reviewed hundreds of exchange transactions from major banks and credit unions in North America and have not yet come across a transactions where the rate wasn't the better rate.

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2) Monitor the degree to which management or staff are using lower cost providers. Keep in mind that it can take additional time to transact all large dollar volumes via Wise vs using traditional banks and credit unions' online banking exchange capabilities. In some cases, owners or managers may decide that this convenience outweighs the cost consideration. Often, attention to FX transfers can also help the company to consider its pace and volume of currency transactions. Are these transactions opportunistic and proactive, or reactive? Many companies FX transfers fall into the latter category: an operating account in a base currency falls unexpectadly low, necessitating an immediate transfer from whichever account is available and has a surplus.

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We'll briefly introduce the value and importance of having a cash management strategy, which is a great accompaniment to the overall company's financial plan and short term outlook. This is the realm of the controller, and this functional role has a lot of value to offer in helping companies anticipate cash shortfalls such that a plan can be prepared ahead of time.

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#2 Consider Adopting an FX Transfer Threshold for Best Pricing

AKA: Avoid Unnecessarily Padding the Bottom Line of Your Local Bank, Credit Union or payment gateway provider (e.g. PayPal).

Many businesses rely on their local bank, credit union or an online payment gateway such as PayPal to run their business. It's extremely common for Canadian and US businesses to receive payments in EUR, USD, CAD or other currencies, and then regularly buy/sell currencies as a part of their regular activities.

For many, the most convenient option is to then use online banking to complete foreign exchange transactions. Sometimes these transactions are about covering a cash shortfall in one currency with a cash surplus in another account. At other times, foreign payments are regularly converted into base currency amounts as a part of a regular monthly procedure. Regardless of the business purpose, the common denominator is: 

• Currency exchange transactions are completed with online banking (it's convenient)
• Currency exchange transaction *pricing* is completed without comparing prices from other brokerages or providers

For most businesses, the convenience factor is very compelling. And, it may be reasonable to apply a *threshold*, below which convenience factors outweigh cost factors. Perhaps for a small business, that amount is $5,000, $10,000, $25,000 or $50,000 USD equivalent. FX transfers below these thresholds are excluded from seeking best pricing. Keep in mind that having a per-transaction threshold may not be meaningful for every business. For example, a business that completes a large number of small (below threshold) transactions may experience more foreign exchange pricing risk than a similar business with one or two above threshold transactions: 

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Business A has a best-pricing transaction threshold of $5,000 USD equivalent.

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200 transactions are completed via the local bank/credit union/PayPal in the quarter with a median value of $3,500. On average, 1% of foregone FX spread is lost due to not seeking out best pricing.

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Foregone profits (expenses that could have been avoided) are estimated at $7,000 USD.

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Business B has a best pricing transaction threhold of $50,000 USD equivalent.

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5 transactions are completed in the quarter via the local bank/credit union/PayPal with a median value of $20,000. On average, 1% of foregone FX spread is lost due to not seeking out best pricing.

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Foregone profits (expenses that could have been avoided) are estimated at $1,000.

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Conclusion: each business should review its prior history and anticipated future need for FX transactions, and implement an appropriate policy to manage FX pricing risk. In certain cases, a volume based best pricing threshold is a better choice.

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#3 Establish a Currency Management Plan for Excess Cash

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Excess cash is both a blessing a curse for most companies. It can be a sign of healthy cash flow from operations, or success raising cash flows from financing sources. However, how much cash constitutes "excess cash"? Companies should always attempt to maintain healthy liquidity at all times, and should have some cash on hand for opportunistic purposes, perhaps an investing cash flow, or a sizeable expense. As we consider these internal usage factors, we should also pay attention to external factors that relate to these internal needs and constraints. If we expect to spend our cash on hand, when might this be? What currency do we need our cash to be in? What is the opportunity cost of our cash on hand? 

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A company should have a clear idea of its costs of capital, liquidity needs and investment plans such that it can craft a currency and cash managemetn plan for the year ahead. This work is complimentary to the company's overall financial planning approach: looking ahead to help identify possible risks and opportunities such that they can be exploited.

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Here are some common examples of company's exposed to currency risk, opportunity cost risk and other risks.

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Example 1: Fiery Hot Sauces Inc.

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Fiery Hot Sauces Inc.. The Nation of Xanadu has recently seceded from a large currency and trade union. The economic outlook is cloudy and political instability is significant. Short and long term currency outlooks for the XAN currency are negative. Fiery Hot Sauces Inc., primarily earns and spends money in Carolingia's currency, the CAR. Nonetheless, the company has maintained 90% of its cash in XAN in an account with no yield. After several years of the XAN depreciating against the CAR, Fiery's CFO is concerned that trading out of the XAN at this time may be unwise as it has potentially already suffered most of its depreciation relative to the CAR. Perhaps there is some upside in the XAN at this stage? The company has no plans to spend or invest using the XAN

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What are some issues here? What risks is Fiery exposed to? What could it do, or have done differently to mitigate some of these risks? 

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• Key questions we would review would be: what is the strategy behind the concentration of currency in XAN? If there is no valid basis for this, we would typically suggest a more diversified approach. However, crystallizing losses by moving out of a depreciated currency is also worth a review. Forming capital market expectations for currencies is a fraught exercise, and currencies are famous for behaving quite differently from how expectations models would anticipate. Nonetheless, a graduated move out of XAN and into CAR likely makes sense.
• What is the time horizon for this cash to be used? If there are no near term investment needs, and the owners do not immediately wish to distribute a dividend, we might look at appropriate yield offerings within each currency. Amounts not needed by the operating company should generally be stripped from the balance sheet and allocated to a holding company that can employ a dedicated cash management or short term investment strategy.
• Finding the right balance between liquidity on hand and the opportunity cost of holding excess cash is important. Each company and ownership team is different and has different liquidity and investment risk preferences. It is important to recognize that not making a decision is still making a decision, and that default decisions, should as retaining large amounts in habitual currencies can be more risky than one might think. Risk cannot be avoided, it can only be managed (or not!).

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Example 2: Grey Area Consulting Inc.

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Grey Area IT Consulting Inc. Grey Area is also located in CAR and has access to a very large operating line of credit. Interest rates have been increasing lately, and Grey Area has been paying increased interest costs on the $500,000 that it has drawn on its $600,000 operating line of credit. The economic outlook is mixed and there are expectations that CAR may experience a period of low economic growth, or possibly a recession. Yields on 10 year bonds are lower than yields on 1 year bonds in CAR currency. Short and long term currency outlooks for the CAR are reasonably positive. The company has $2,000,000 of cash on hand, and no major plans for these funds. The company also maintains a holding company owned by the same principals, with a further $1,000,000 of CAR cash yielding 1% in a high interest savings account. The operating line of credit interest rate is prime + 4%, with the company's most recent loan statement indicating a prime rate of 4%.

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What are some issues here? What risks is Grey Area exposed to? What could it do differently to mitigate some of these risks? 

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• Key questions we would review would be: what is the rationale behind the companies margin approach? Margin exists whenever an entity is simultaneously borrowing and holding cash or investment assets. Here, the margin approach looks like it may not be ideal. While the company has strong balances on hand, the company is increasing its interest costs without having a return in company profits or investment yield to show for it. This could be less than ideal capital management, and despite tax deductability benefits, will negatively impact the company's bottom line. Such an approach can be justified if there are near term investments that the company is considering, however, so a detailed review is important.
• If the company deleverages, the owners might be advised to distribute excess cash in the form of a dividend, or to transmit funds to a holding company for a suitable investment strategy. Generally speaking, excess cash beyond that required to meet liquidity and solvency risk needs, or investment purposes, should be moved off the balance sheet.

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Conclusion: The larger take away here is that a company needs to build an appropriate strategy for its excess cash. That strategy should be complimentary to the company's mission and near term financial outlook. The plan should weigh internal and external factors and balance risks and opportunities. We hope by reviewing some examples, you can see the value of adopting a well defined strategy in this area.

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