In collaboration with Steve Paul, Deputy CFO, Equals Money
It used to be just large multinational companies and government organisations who benefitted from currency hedging. Today, businesses of all sizes who trade internationally are discovering how this strategy can protect their budgets from sudden changes in international exchange rates.
Currency hedging is indispensable for anyone involved in international finance. As the name suggests, it is about limiting risk, or losses, to fluctuations in international currency. It offers increased financial predictability and stability.
In recent months, volatility in the world’s $7.5 trillion currency markets has been at its lowest in years, tempered by a strong dollar and coordinated central bank caution on inflation. With signs of relaxation in monetary policy and a significant November election in the US, however, this low-level volatility could be about to change.
Why does this Matter to your Business?
Most businesses today operate internationally in one form or another, either through their supply chain or customer base. This can mean receiving and paying out funds in multiple currencies.
Unless you apply a strategy like currency hedging, these transfers will be taking place at whatever the current exchange rate is for the currencies you are dealing with. There can be huge fluctuation in these rates, particularly in times of economic uncertainty, making it difficult to budget or forecast accurately. This potentially exposes your business to hidden costs if sudden rate changes are less favourable than expected.
When to Hedge?
If you’re supplying goods and services or using suppliers overseas, it is advisable to consider currency hedging in the procurement and contract stages of an agreement, especially agreements for larger orders or contracts.
A longer-term strategy could be applied when setting annual or project budgets, but it would require having a clear idea of what currency will be needed and in what quantities with some certainty.
What Type of Hedging to use?
The type of currency hedging that you chose will depend on your business model, the timeframe involved and the flexibility of your budget or cashflow.
A common approach is ‘foreign exchange (ForEx) options’, also known as ‘currency options’, which allow you to buy or sell a particular currency at a specific exchange rate, or strike price, before the option expires on a specified date. Two variations on this are ‘European-style options’ where you agree to buy and sell a currency at any point between two dates, or ‘American-style options,’ which specify a particular expiry date. These are most likely to be used when you have a high level of certainty about the amount of foreign currency needed and the dates of payment.
‘Forward contracts’, on the other hand, lock you into in the current exchange rate for a period of time, for example for a quarter of a year or even up to two years. That way you know exactly what your outgoings are in that currency and are protected from any future drops during that time.
Are there any Risks?
It’s important to understand the pros and the cons of any financial strategy.
Hedging is commitment to the rate you’ve booked, regardless of how it moves after the fact. This rate could obviously improve as well as decline. Many find the stability and certainty of a forward contract outweighs the possibility of a rate moving in their favour though.
Clarity on timing and certainty on expenditure is vital. You don’t want to book currency at a preferential rate only to discover that those funds are no longer needed for that purpose, or for a supplier in that currency.
You need understand, or to seek consultancy, on your business’ particular risk exposure and tolerance. Your strategy needs to align with your business goals, while taking into account the wider market dynamics that could impact your investments and operations.
Navigating Hedging
It’s becoming increasingly easy to hedge currency thanks to a variety of payment platforms that are now available to businesses of all sizes. If hedging for the first time, make sure that you choose a partner who is able to use their expertise to guide you through the process more closely.
Without hedging, business that produce or trade internationally open themselves up to financial risk, which many can’t afford in the long run. By working with knowledgeable advisors, business leaders can use this helpful financial tool to protect their companies from unexpected losses and manage financial risk more effectively.
