Currency risk and forwards: how to protect margins, costs and cash

Selling into new markets, diversifying customers and joining international supply chains can accelerate a company's growth. However, when a sale, a purchase or a loan is denominated in a currency other than the euro, an additional variable comes into play: the exchange rate.

Weeks or months can pass between the commercial negotiation and the receipt or payment. In that interval, a currency movement can reduce the value of a sale, make an import more expensive or increase the cost of a debt.

Managing this risk does not mean trying to predict how currencies will behave. It means knowing the exposure, defining how much risk the company is willing to take and protecting the financial objectives that matter.

Currency exposure generally takes three forms.

Transaction risk relates to specific amounts receivable or payable in another currency: for example, an export invoiced in dollars or equipment bought in pounds.

Economic risk is the effect of exchange rates on future prices, costs, margins, competitiveness and cash flows. Even a company that invoices only in euros can be affected if its competitors, customers or suppliers operate in other currencies.

Translation risk arises mainly in groups with subsidiaries, assets or liabilities abroad, when currency movements change the amounts reported in the consolidated financial statements.

This distinction matters because not all currency exposure can be treated in the same way. A forward can be effective in hedging an identified transaction, but on its own it does not remove all long-term economic exposure.

The first step in a currency management policy is therefore to identify and measure the relevant exposure.

What is a currency forward?

A currency forward is a contract under which two parties agree today to buy or sell a given amount of one currency against another, at a rate set in advance, for a future transaction.

For a company whose reference currency is the euro, the instrument makes it possible to know in advance the euro value of a future receipt or payment.

A traditional forward sets a notional amount, the currencies involved, the forward rate and the maturity, that is, the contractual date on which the transaction is settled.

With fixed forwards, the company knows in advance the exact maturity on which it intends to carry out the transaction. There are, however, more flexible structures, such as window forwards, in which the contracted rate can be used within a pre-defined time window.

The forward rate should not be confused with a forecast of the future exchange rate. It is a rate agreed today for a future transaction, derived from the spot rate and the funding and market conditions of the two currencies, including the interest rate differential and the costs and spreads applicable to the transaction.

A forward normally creates a contractual obligation. At maturity, the company must buy or sell the currency on the agreed terms, even if the market rate has since moved more favourably.

Nor should a forward be considered a cost-free instrument. Although there is usually no upfront premium comparable to that of a currency option, the company should assess the contracted rate, spreads, any margin or collateral requirements, and the costs of amending, cancelling, closing out early or extending the contract.

Example: hedging an export in dollars

Imagine a Portuguese company selling goods for 500,000 dollars, with payment expected in 90 days.

On the contract date, the EUR/USD rate is 1.10. At that rate, the receipt is worth around 454,545 euros.

If, at maturity, the rate rises to 1.18 — reflecting a stronger euro against the dollar — the same 500,000 dollars are worth approximately 423,729 euros.

The difference, more than 30,000 euros, directly reduces the euro value of the revenue and can undermine the margin originally planned.

To limit this uncertainty, the company can take out a forward to sell the 500,000 dollars at, for example, a rate of 1.11.

It thereby locks in a receipt of approximately 450,450 euros, whatever the spot rate at maturity.

There is, however, a trade-off.

If, at maturity, the EUR/USD rate falls to 1.04, without a hedge the company would receive around 480,769 euros. With the forward, it keeps the amount contracted in advance.

The aim of the instrument is not to obtain the best possible rate. It is to protect a margin considered acceptable when the deal was closed and to reduce uncertainty about the future cash flow.

The figures shown are purely illustrative and do not include spreads, fees, margins or other contractual conditions.

What can a forward bring to financial management?

The main advantage is predictability.

By fixing an exchange rate for a future transaction, the company reduces uncertainty about the amount it will receive or pay in euros.

This can help to:

• protect the margin on an order;
• prepare more reliable cash flow forecasts;
• set prices for foreign customers;
• stabilise import costs;
• reduce swings in financial results;
• align future receipts with loans or other commitments.

The effect is particularly relevant in businesses with thin margins, long payment terms or a heavy concentration in one currency.

Currency management can thus stop depending on decisions made on the expectation that a given currency will rise or fall.

Risks and limitations of forwards

The predictability a forward provides does not remove every risk. A poorly sized hedge can even create a new exposure.

The first limitation is giving up a favourable movement. Once the rate is fixed, the company is bound by the contracted terms. If the market moves favourably, it does not fully benefit. This feature distinguishes a forward from a currency option, which can offer more flexibility, albeit with a different cost structure.

There is also the risk of mismatch. If the customer pays later, the invoice amount changes or the commercial transaction does not go ahead, the forward remains in place. It may be necessary to amend the contracted terms, adjust the maturity, reduce the amount, extend or roll over the contract, or close out the position at the market conditions of that moment.

Over-hedging is another important risk. Fully hedging revenue that is still uncertain can force the company to deliver currency it never received. Confirmed exposures and commercial forecasts should therefore be treated differently.

The following should also be considered:

• counterparty risk;
• settlement risk;
• credit, margin or collateral requirements;
• the liquidity of the instrument;
• the conditions for amendment or early termination;
• the costs of extension, renewal or restructuring.

There is also a liquidity risk that should not be ignored. Depending on the contractual structure and the counterparty, an adverse market movement can trigger additional margin or collateral calls. A hedge that protects the economic margin should therefore not be assessed separately from the company's cash capacity.

Maturity should also be part of the decision

Choosing a forward is not only about deciding how much to hedge and at what rate. It is equally important to decide when the hedge should be settled.

The maturity should be aligned, as far as possible, with the moment the company expects to receive or pay the foreign currency.

When the date of the cash flow is known precisely, a fixed forward may be appropriate. When there is uncertainty about the exact timing of the receipt or payment, a structure such as a window forward can offer more flexibility, allowing the contracted rate to be used within a pre-defined window.

If the commercial transaction changes and the originally contracted maturity no longer matches the actual cash flow, the company may have to consider an extension or rollover, a contract amendment or closing out the position, always in line with the applicable conditions and the market value at that time.

Maturity should therefore not be seen as a mere operational detail. It is one of the fundamental variables of the hedging strategy.

Hedging 100% is not always the answer

An effective policy does not necessarily have to eliminate all currency exposure.

The level of hedging should reflect the predictability of the cash flows, the margin on the transactions, risk tolerance, financial capacity and the company's time horizon.

An organisation with relatively stable monthly receipts in dollars could spread the hedge across different maturities, building a progressive hedging strategy or rolling hedge. In this model, part of the future currency needs is hedged on a recurring basis, extending protection over time.

Another company, with commercial proposals not yet awarded, might hedge only a percentage of the expected exposure.

Where there is greater uncertainty about the amount or timing of the cash flow, more flexible solutions can be considered, such as currency options or different forward structures.

Before turning to derivatives, it is also important to identify natural hedges. Receipts and payments in the same currency can partly offset each other. The company can also negotiate prices, buy raw materials, borrow or hold cash in the currency in which it generates revenue.

The goal should be to manage the relevant net exposure, not to hedge every transaction automatically and in isolation.

Six steps towards a more consistent currency policy

1. Map the exposures

Identify receipts, payments, loans and commitments by currency and maturity, separating contracted transactions from mere commercial forecasts.

2. Calculate the net position

Offset inflows and outflows in the same currency and recognise the natural hedges already in place.

3. Set objectives and limits

Determine which margins or cash flows should be protected, the minimum and maximum hedging levels and which deviations are acceptable.

4. Choose instruments and maturities

Compare forwards, options, swaps and operational solutions, considering not only the rate offered but also flexibility, maturity, credit risk, collateral, liquidity and the costs of amendment or extension.

5. Monitor and report

Regularly review forecasts, contracts, maturities, deviations and results.

The policy should define who identifies the exposure, who authorises the hedge, which counterparties can be used and how proposals are compared.

6. Assess hedge effectiveness

Check whether the strategy is actually achieving the defined objective: protecting the margin, reducing cash volatility or increasing the predictability of cash flows.

Among other aspects, the company should analyse the level of hedging actually achieved, deviations between expected and actual exposures, the cost of hedging and the impact on margin and liquidity.

This discipline reduces reactive decisions based only on the expectation that a currency will rise or fall.

Predictability, not speculation

A forward should be used to manage an identified exposure, not to try to anticipate the market.

The difference is fundamental.

A hedge seeks to reduce the uncertainty linked to a real commercial or financial transaction. A speculative position seeks to profit from movements in the exchange rate.

Corporate use of forwards is normally tied to identifiable commercial or financial needs, not to pure speculation on currency movements.

Nor should a hedge be judged only by comparing the contracted rate with the rate that ended up prevailing in the market.

If the market moved favourably, that does not necessarily make the decision wrong. The company gained predictability and protected a result within the parameters it had set.

The assessment should consider the objective originally set, the exposure actually hedged, the cost of protection and the impact on margin, results and cash.

Managing the risk before closing the deal

Currency management should begin when the price is being set and the payment terms negotiated, not only when the invoice approaches maturity.

The invoicing currency, payment terms, advance payments, price revision clauses and the possibility of offsetting cash flows are commercial decisions with a direct impact on financial risk.

Forwards can make revenue, costs and margins more predictable, but they should be part of a policy based on up-to-date information, decision rules and regular monitoring.

The starting point is not choosing a financial product.

It is understanding how much the company could lose, which margin it wants to protect, how predictable its cash flows are, which maturity makes sense and how much flexibility it needs to keep.

Does your company sell, buy or borrow in a foreign currency? Contact our team to map your exposure, test different scenarios and define a currency management policy suited to your international strategy and your organisation's financial capacity.

This article is for information purposes only and does not constitute an investment recommendation, a contractual offer or individual financial advice. The features, costs, risks and accounting and tax implications of any instrument must be assessed for each company and transaction.