3 crucial FX rates

When managing FX issues within companies, there are three very important rates which need to be understood and considered. For those that don’t grasp their meaning, or their contribution to the bigger picture, it can mean increased confusion, higher costs and reduced efficiencies. In short, if you get these right and understand how adverse effects upon these rates can be smoothed out, then the management of the FX risk becomes a lot easier.

The rates are: Planning, Accounting and Execution.

Planning Rate

As part of a company’s budgeting process, the team responsible for financial planning and analysis must make key projections for the coming period. A priority within that often complex process is a forecast of the representative rate being used when converting local currency to functional/reporting currency. This is necessary if future earnings, or expenses are to be accounted.

The desired result of the process is the same for all companies – a figure on which the forecasts can be built – but how they get there will vary from company to company. It might even differ within subsidiary companies of the same Group, even though the central financial function should have consistent practices across all operations.

Transactional Accounting Rate

This is the rate at which new transactions will be booked. It is generally set every month, but individual companies will usually choose from one of three methodologies which are commonly used.

The first is the daily rate which provides good visibility, but over a company which might be completing thousands of transactions within a month, it’s clearly not practical. Next up is the average rate which although it’s better than the daily rate, it has two distinct disadvantages. It cannot be determined until the last day of the month in question and involves far more work for the financial team.

Arguably the best compromise is the prior-end rate which is considered by many to be the most effective. Let’s look at the advantages. As it’s a single number, it’s suitable for firms with a large number of transactions. Then, because it’s known before the month starts so to speak, the financial team don’t have to wait until the month end to start their calculations, thereby avoiding the extra workload. What’s more, because it is the same rate used to calculate balance sheet re-measurement, it makes combining balance sheet and cash flow hedging easier.