5 questions to ask before your company considers foreign exchange hedging
If your company is weighing up the pros and cons of foreign exchange hedging, take a look at our five-point checklist…
Five key questions to ask if your business is keen to decide whether foreign exchange hedging might be a good option:
Q1. What do I hope to achieve from my currency hedging strategy?
As with any strategy you need to have a clearly defined goal. To a certain extent, your goal will help you determine whether to hedge and which may be the most suitable foreign exchange (FX) hedging products to meet your needs.
As the currency market has been volatile in recent times, your goal may simply be to protect your business from foreign exchange losses. Adverse currency market movements can have a direct impact on your company’s profitability. In this scenario you might consider using a foreign exchange forward contract. This allows you to fix the FX rate for a set time period.
Q 2. What impact would a 10% move in the FX market have on my business?
You may think a 10% currency market move is unlikely but, given the current political and economic environment, we cannot rule it out. Put your foreign currency exposure in the context of your profit margins. If you’re an importer or exporter with a profit margin of 10% or less then a swing of this degree could wipe out your profit and may result in you making a loss.
Also consider if you’re in a very price competitive commoditised industry. A couple of percent variation in your price due to a 10% move in the currency market may result in competitors taking business from you.
In this situation foreign currency hedging may be a good option. It allows you to fix the exchange rate for a set time period and accurately forecast your profitability on future sales over this period.
If you have a much larger profit margin than 10%, you may think you can absorb the losses if the market moves against you and enjoy the gains when the market moves for you. However, even in this situation you may decide to hedge 50% of your exposure when the market is favourable. You then know you have a fixed rate on a share of your currency exposure for times when the market is against you.
Q 3. How easily and quickly can you re-adjust pricing with customers or suppliers?
If your business prices each piece of work individually and the time between quotation and acceptance is relatively short, you’re probably less sensitive to currency market movements. In this scenario you may decide to adjust your pricing according to the FX rate when you provide a new quote to customers.
If, however, your pricing is only updated once or twice a year (in a catalogue, for example) you’re more at risk from currency market movements. Many retailers and travel companies fall into this category. If you are an importer or exporter in this situation you may choose to fix the FX rate for the catalogue period in order to protect yourself from any adverse currency market movements.
Q 4. Can I accurately forecast business currency requirements?
Is it possible to accurately forecast how much currency you’re going to need to buy or sell over the next one, three, six or twelve months? If you’re a well-established business this is much easier as you have historical data to help forecast future requirements.
You may find forecasting more challenging if you:
are a new business
have just started working with a new overseas distributor
have a new product or service and don’t know how well it will sell
Most forward contracts and structured products require you to commit to an agreed sum of currency over a set time period. Therefore, should there be a significant drop in your currency requirement, you are still committed to the contracted amount of currency. Whilst you may be able to sell the contract back to the market, if the contract has devalued you may be liable for any losses.
If there is a level of uncertainty over your requirements you can still protect yourself using foreign exchange hedging products but you may choose to only hedge 50% of your requirements and use the daily currency rate (spot market) for anything else you need. In this way you limit the potential downside if the FX rate moves against you and won’t leave yourself over-committed should your situation change.
Q 5. Do I have cash flow that can support my currency hedging requirements?
If your business is tight on cash flow, you may need to think about the following:
Can I afford to pay a deposit of 5% of the total currency hedged up front?
Some providers may ask you for an upfront deposit to secure the currency contract, which is returned once the contract has matured. This gives the provider security should you default.
Can I afford to make further deposit payments if the currency market moves more than 5% against the contract?
If the market devalues the contract by more than 5%, some providers may ask for an additional deposit payment, which could be another 5% of the value of the contract. This is often known as a “margin call”.
Will I have the funds available when the contract matures to cover the contract?
On maturity, you may be obliged to pay the remaining balance of the contract. Therefore, you need to make sure you have the funds available to settle with your provider.
If you answered “no” to any of these questions you may not have the available cash flow to hedge at this time.
It can be difficult to assess whether your business is ready to hedge currency, and what products may be suitable. These questions are a good starting point, but if you’d like to discuss foreign currency hedging with one of our experts, speak to one of our team today.