FX Operational Risk: The Margin Squeeze After a Devaluation

When a company talks about currency risk, it usually means its hedges: forwards on dollar payables, perhaps a swap on foreign debt. Those instruments manage the exposure finance can see on the balance sheet. The larger exposure is in the operations, where the currency of costs and the currency of prices do not match and do not adjust at the same speed.

Three exposures, three horizons

• Transaction exposure: invoices and payments already contracted in foreign currency. Short-term, visible, and easy to hedge with forwards.
• Translation exposure: the accounting effect of converting foreign subsidiaries into the reporting currency. It moves equity and reported results, but not cash.
• Economic (operating) exposure: the effect of a currency move on future revenues and costs, through prices, volumes, competitors and suppliers. It is the largest of the three, it lasts for years, and no forward contract covers it.

The margin squeeze

Consider a distributor that imports 60% of its cost of goods and sells in local currency at a 35% gross margin. The currency loses 25%. Import costs follow within two months, as the stock bought at the old rate runs out. Prices follow more slowly: customers resist, competitors with local supply hold their prices, and contracts reprice only at renewal.

The damage happens in the gap between the two lines. For several months the company sells stock replaced at the new rate for prices set at the old one, and the margin falls by nine points. Even after prices adjust, the margin settles two points lower, because full pass-through would lose volume to competitors. The hedging programme, meanwhile, has protected only the payables that were open on the day of the devaluation: a few weeks of imports.

Managing the exposure in the operations

Operating exposure is reduced by redesigning the business so that costs and revenues move together, a natural hedge. Financial hedges then cover only what remains, and buy time.

1. Index prices where the market allows it. Contracts with large customers can carry an exchange rate clause or be priced in dollars. This alone halves the exposure in the example.
2. Match the currency of costs. Local suppliers, local assembly or regional sourcing reduce the share of costs that jumps with the currency.
3. Shorten the price response. Pricing authority, price lists that can be updated weekly and a pre-agreed pass-through policy reduce the months of squeeze.
4. Hedge what remains, for time. A rolling forward programme does not remove the economic exposure, but it spreads the shock over twelve months, the time the operating levers need to work.