Deadly Assumptions: FX and FP&A
Deadly Assumptions: FX and FP&A
Dispelling the Top Four Myths of Foreign Exchange Risk Management
Summary & Key Takeaways
Foreign exchange risk rarely announces itself loudly, yet its effects are often anything but subtle. In FP&A, where models are built to guide real-world decisions, the greater danger lies in assumptions that feel reasonable but fail under scrutiny.
FX exposure is not immaterial, nor does it conveniently normalize over time; market movements are asymmetric. At the same time, long-held beliefs about the cost and constraints of hedging have not kept pace with market realities, leaving many firms overexposed by default rather than by design.
What follows is less a set of technical observations than a practical warning: when FX risk is understated or misunderstood, it does not disappear. It accumulates and eventually expresses itself in margins, cash flow, and strategic outcomes.
The core ideas can be distilled simply:
FX risk can be materially impactful, even in developed market currencies
Exchange rates do not “even out” over time, and often move asymmetrically
Hedging is frequently less costly, and more accessible, than assumed
Outdated views on collateral requirements and opportunity cost may no longer fully apply
Weak FX assumptions lead to flawed forecasts and poor decision-making
Models are only as good as their assumptions.
When it comes to financial modelling and the FP&A process, the above is a truism that cuts across time and technology.
Much has been made about the rise of AI, its implications for financial professionals, and the features touted by tech optimists. Since the outputs of LLMs are probabilistic rather than deterministic, they run into the same cold hard realities that are present in applied statistics and financial modeling.
Garbage in = Garbage out.
The financial analysis and planning process is essential for providing the business intelligence and roadmap that executives need to allocate resources and exercise judgement in implementing strategy
Foreign currency exposures add complications and scope for faulty assumptions that can lead to costly misjudgments. In this piece we will cover a few key ‘deadly assumptions’ that FP&A teams need to be aware of.
Myth Number One: FX risks are immaterial
FX risk is often viewed as immaterial, due to:
lack of visibility into the impact of FX variation on financial results
misconceptions about both the size and frequency of price movements in FX markets
While the former is beyond the scope of this writing, the latter reason is easily refuted by the historical analysis of average FX ranges seen in select developed market currencies below. Depending on where FX hits a business’s financial statements, it can have a decidedly material impact on the business’s profitability, cash flow and even long-term financial sustainability.
Even developed-market currencies can move as much as 20% in a year.
Consider the case of an importer with substantial cost of goods sold denominated in EUR and funded by USD revenue. Assuming $3M EUR per month in exposure at a EURUSD rate of 1.2000, a monthly variation of $432,000 USD directly hitting gross margin would be hard to hand-wave away for most mid-sized companies.
Myth Number Two: FX rate movements even out over time
This is a big one. It is often assumed that the law of large numbers assures that FX rates ‘even out’ over time. This assumption can potentially lead to the destruction of an FX-exposed business. In fact, FX spot movements are not normally distributed, and this is true even for developed market currencies.
Potentially more impactful is the fact that the world’s reserve currency, the US dollar, possesses considerable skew in returns relative to the majority of its counterparts. Price action in that currency is especially asymmetric in bouts of risk aversion, meaning FX volatility can exacerbate challenges arising in other parts of the business simultaneously.
In other words, increased risk aversion often pushes up the US dollar against many other currencies, which can make things worse for many businesses already suffering due to the underlying circumstances causing the risk aversion in the first place.
Myth Number Three: FX hedging is necessarily expensive
Admittedly, this myth used to have some truth to it.
Hedging costs for forward contracts are largely a product of interest rate differentials between currencies. Despite the increase in interest rates from post-COVID inflationary shocks, hedging costs are still relatively low across most currency pairs. In fact, across many currencies in the developed world, hedging costs are still often far below the average range of movement in those currency pairs.
Further, savvy treasurers can exploit positive yield differentials by hedging forward sales or purchases when forward markets present better pricing than spot markets. This is especially true for US based importers sourcing from higher yielding countries (i.e. whose central banks have set relatively high interest rates) like Mexico, Brazil or South Africa.
Myth Number Four: FX hedging has substantial opportunity costs
Traditionally, hedgers would have to post a collateral deposit to support hedging activities. This collateral commitment ties up working capital and can present cash drag on portfolio returns.
Normally, collateral required could amount to 3-5% of the notional amount being hedged. Fortunately, within the FX space in particular, the provision of unsecured credit facilities by brokers and banks has become a more common practice. This has largely eliminated the need for collateral commitments or daily monitoring of margin requirements.
Assumptions not grounded in reality make for poor models; garbage in, garbage out always applies.
FP&A serves to provide executive teams with the data they need to make sound decisions and guide the future of a business. Decisions made on unsound assumptions around foreign currency can result in a roadmap that leads to a dead end.
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FAQs
Why is FX risk often underestimated in FP&A?
Because it is not always directly visible. Currency impacts can be embedded across revenue, costs, and balance sheet items, making their effects harder to isolate. This lack of visibility, combined with assumptions about stability, often leads teams to understate the risk.
Do currency movements really matter for developed market currencies?
Yes. Even relatively stable currency pairs can move meaningfully over short periods. These movements, while appearing modest in percentage terms, can translate into significant impacts on margins and cash flow.
Is it reasonable to assume FX rates will balance out over time?
No. FX markets are not normally distributed and do not behave in a way that guarantees mean reversion over a planning horizon. Movements can be directional and asymmetric, particularly during periods of market stress.
Is FX hedging expensive?
Not necessarily. Hedging costs are largely driven by interest rate differentials, which in many cases are modest relative to the typical range of currency movements. In some scenarios, hedging can even be economically favorable.
Does hedging tie up significant working capital?
Historically, it often did. However, the increased availability of unsecured credit facilities has reduced or eliminated the need for collateral in many cases, lowering the operational burden of hedging programs.
What is the real risk of getting FX assumptions wrong?
Flawed assumptions do not remain isolated within a financial model. The model influences decisions that, over time, can lead to misallocated resources, compressed margins, and decisions that fail to hold up under real market conditions.
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