“Risk Management in Foreign Exchange for Cross-Border Payments: Strategies for Minimizing Exposure”

Abstract

The volatility of global currency markets presents a major challenge to firms engaged in cross-border payments with foreign exchange (FX) risk. This study examines different FX risk management strategies, and specifically the effectiveness of hedging instruments, i.e., options, futures, and forward contracts, in reducing currency exposure. A study of major currency pairs from 2015 to 2019 shows that EUR/GBP and USD/GBP pairs are highly volatile, mainly influenced by geopolitical factors such as Brexit. Results are quantified and show that options contracts are the best at mitigating FX risk, reducing exposure by an average of 31.8%, followed closely by futures and forward contracts. Smaller risk reduction is provided by natural hedging, an imperfect solution but indicating the need for a diversification approach. The firms that did not use any hedging strategies had higher exposure to FX risk. Interviews of firms reveal that hedging is effective, but that cost and operational complexity may inhibit some firms from using these strategies. In general, the study emphasizes the need to adopt a comprehensive FX risk management framework that incorporates financial instruments and natural hedging to stabilize the financial condition in cross-border transactions.