Mitigating exchange rate risk
FX risk hedging is one of the two main motives that drive the FX market, the other being speculation. Exchange rate risk or forex risk is an unavoidable risk of cross-border business and foreign investing. Consideration and management of the risk are key in improving profitability.
For companies relying on a global supply chain or for those selling their products in foreign markets, exchange-rate variations can increase costs or slash revenues, ultimately eroding their profit margins and damaging their financial statements. As a manufacturer for example, profit margins could be squeezed by number of ways: a rise of the US dollar will make dollar-denominated raw materials more expensive; a fall of euro will make selling in Europe less profitable.
Unmanaged foreign currency exposure adds risks without adding expected returns. The financial impact of FX fluctuations is often underestimated as businesses and investors lack awareness or capacity to develop and implement risk management strategies.
Hedging can be compared to an insurance policy that limits the impact of foreign exchange risk. The risk can be mitigated considerably with different types of contracts that are designed to achieve specific goals. These goals are based on the level of risk the hedger is exposed to and seeking protection from and allow the client to lock in future rates without affecting, to a great extent, their liquidity.
Currency forwards and futures are simple contracts that can be effectively used for this purpose. With only a small amount of upfront margin, the client can lock in the exchange rate in advance and ensure certainty in their cash flows. The advantage of forward contracts is that they can be customised to specific amounts and maturities while futures are only available for fixed dates as they trade on an exchange.
Currency options offer another feasible alternative to hedging exchange rate risk. They give a client the right to buy or sell a specific currency in a specified amount on or before the expiration date at the strike price.
When considering a hedging strategy, the first step would be to take note of potential foreign exchange exposure and, based on that, design a strategy tailored to specific FX needs and objectives and the amount of risk to tolerate. One critical question for example is whether it should be a full, partial or no hedge at all. The answer will depend on a number of factors such as cash streams, costs, risk tolerance, and market conditions, etc.
Depending on a company’s production and sales cycles, the volumes of foreign currencies it handles and its exposure, currency hedging can be a simple or complicated task. In some cases, simple FX alerts or market orders that allow the company to trade at the most convenient moment would be sufficient. In most cases, however, the company must purchase financial products like currency forward contracts to lock in an exchange rate for a predefined period of time. Businesses with more complex cash flow streams, or those exposed to a significant number of currencies, need sophisticated solutions with a high degree of automation.
When well-implemented, FX hedging is an efficient way that can save the bottom line. However, the risk here is to hedge when the market goes in the client’s favour and hedging could lead instead to substantial and unnecessary losses. That is why market insights by knowing which way the currency wind turns is the first step in designing a mitigation strategy.