Why Hedge? Four common approaches to FX risk management

Published February 14, 2018

By Phil Lynch
Corporate Hedging Director – Asia Pacific

Introduction to Hedging

Before we look at the key topic of this article (why businesses hedge), it is important to understand what foreign exchange hedging is. There is such a wide spectrum of understanding when it comes to foreign exchange hedging. When I tell people I work in hedging, I get anything from, ‘Oh cool you work for a hedge fund,’ to, ‘You cut hedges? Why are you wearing a suit?’

To summarise: foreign exchange hedging is a way for a business to minimise, mitigate, or eliminate foreign exchange risk, which is the financial risk that exists when a financial transaction is denominated in a currency other than the base currency of the company’s operations. Foreign exchange risk broadly impacts a range of stakeholders from customers, finance teams, purchasing officers, sales staff, senior management and owners.

Why do businesses hedge – the wrong reasons

Let’s start by looking at some of the wrong reasons why businesses hedge.

• The rates looking good, in someone’s ‘expert’ opinion
• One director got a hot tip (whilst playing golf) that the market had peaked
• Some foreign exchange dealer recommended a hot new product that was too good to resist
• “Hedging is what we have always done”
• “I don’t speculate so we hedge everything”
• “I don’t speculate so we don’t hedge anything”

Believe it or not – the reasons listed above are very common – we hear them frequently when businesses are making foreign exchange decisions. Whilst the reasons above can support a hedging decision, they should not form the basis of a hedging decision.

Why do businesses hedge – the right reasons

There are many reasons why businesses hedge against foreign exchange risk, and these can be broken down into four common buckets:

Each bucket will often overlap – there is no silver bullet to foreign exchange hedging. It is important to understand your reasons for hedging before embarking on a foreign exchange hedging program. Let’s break down these reasons further, below.

Protect Profit Margins

Protecting profit margins is the most common objective in foreign exchange hedging for commercial and corporate businesses. Protecting margins typically falls into one of two categories – either your Cost of Goods Sold (COGS) or your International Sales Revenue. The basic principle is to protect your gross margins from erosion due to fluctuating exchange rates.

If your gross margins are tight (<5%), then your requirement to protect those gross margins is very high. This, in turn, drives your strategy. A 5% or greater move in the currency could wipe out your profitability.

If your gross margins are between 5-25%, you will have more flexibility. If your gross margins are >25%, then fluctuating exchange rates will have a relatively small impact on your margins and you may even opt not to hedge. However, there are few lucky enough to have margins this high!

Additionally, many businesses will have a timeline for protecting profit margins that match their sales cycle. Some foreign exchange hedging is booked to match underlying contracts. Some are booked to cover a season or project. Otherwise, hedging contracts might be booked on a rolling basis.

Stability & Predictability

Volatility, Uncertainty, Complexity & Ambiguity (VUCA); all terms that can make a CFO, Finance Manager, Accountant, Director, or Business Owner lose sleep. Yet foreign exchange markets are the epitome of VUCA. This objective is simple – create stability and predictability in your cashflow and fight VUCA. Foreign exchange hedging contracts provide you with certainty for a known period, allowing you to control your cashflow. Cash is king, after all.

Larger corporations, especially those listed or with complex ownership structures, will often have a shareholder directive to maintain stability in earnings. No CFO wants the share price to plunge in line with currency fluctuations. Stability & predictability can play an important role in meeting shareholder expectations.

Remaining Competitive

One reason you might choose to hedge is to remain competitive. If your competitors are pricing their products based on an average hedge rate, then your pricing might be very different if based on the spot market rate.

By taking foreign exchange hedging contracts in line with your industry standard, you are allowing yourself to compete on the same playing field as your competitors rather than on the foreign exchange market. If you wanted to compete on the foreign exchange market, you could simply place financial bets with a speculative foreign exchange service provider (which is not what we do).

Other

Of course, the reasons to hedge against foreign exchange risk cannot always be perfectly categorised into the above three buckets. There are many other reasons why businesses may legitimately enter into foreign exchange hedging contracts. This might be to offset against commodity price risk, to hedge against balance sheet items, or to take advantage of extreme movements in the exchange rate. So long as the reason is in line with the business’s overall objectives and is known to key stakeholders in advance, it can be considered a good reason to hedge.

Common risk management strategies

An important starting point for businesses managing foreign exchange risk is to consider any internal hedging that can be achieved; this is typically known as a natural hedge. For example, this might be where liabilities denominated in a foreign currency (e.g. COGS) are offset by sales in the same foreign currency. Whilst there can be complexities around cash flow timing, this can be one of the cleanest ways for businesses to manage foreign exchange risk.

However, most international businesses do not have the luxury of having a perfect natural hedge. Therefore, they must use external hedging where foreign exchange based instruments are used to offset business risk. There is a broad range of risk management approaches, and today we list the four most common.

1. Do Nothing

Yes – doing nothing can be an appropriate foreign exchange risk management strategy. However, we would only endorse such a strategy if it was well thought through and well justified.

Put simply, doing nothing means you take the spot rate on the day. This may be appropriate if the risk is not significant. Perhaps the portion of your business denominated in a foreign currency is very low. Or your gross margins are very high. Or the industry norm is for no one to hedge. Whatever the case – doing nothing is rarely the most suitable decision.

2. 100% Hedged

This is where you cannot afford to take on any foreign exchange risk, possibly due to thin margins and the size of your exposure. You might book a hedging contract for every invoice, purchase order, capex item or special project. This approach is useful for businesses who adopt a conservative approach.

3. Pad Profits

This approach is the highest risk approach, where one would actively attempt to pad profit margins through foreign exchange gains. It is suitable for more aggressive businesses who are comfortable taking higher risks. This approach might incorporate the use of more sophisticated products. However, this approach, by nature, is higher risk and is therefore not suitable for most businesses.

4. Strategic Hedging

The most common approach to foreign exchange hedging is the strategic approach. This is where businesses look to reduce risk to the business and add value over time. Strategic hedging requires careful attention to each step within the foreign exchange risk management cycle. Typical objectives would include protecting profit margins and creating stability and predictability. Striking the right strategy or plan might require external input – this is an area where EncoreFX can assist.

Summary

There are many reasons why businesses hedge, both good and bad. The best reasons are those that carefully consider and tie in your overall business objectives. This will help you determine the best approach to foreign exchange hedging for your company.

There is no silver bullet to choosing the best approach, and it can be useful to get expert advice. If you would like to learn more, please feel free to contact me directly. I can put you in touch with an expert in your region.

Phil Lynch – Corporate Hedging Director – Asia Pacific

• +64 9 941 4052
• +64 21 516 826
• plynch@encorefx.com

Next Month

Next month we will introduce the Foreign Exchange Hedging Cycle. This will provide insight on how EncoreFX assists clients in navigating and understanding the risks that they face and how to formulate a plan.

Click here if you want to sign up for future instalments of the EncoreFX CFO Series of Risk Management Articles. Upcoming instalments will include:

• The FX Hedging Cycle – How to Embed Best Practice
• The Importance of a Budgeted Rate and Hedge Ratios