In March, we introduced the FX Hedging Cycle – a five-step approach to managing foreign exchange risk – to share the concepts of identifying exposure to FX risk, setting objectives, and creating a plan to manage your risk. A crucial component which underpins each of these steps is understanding which exchange rate level you are trying to manage risk for. This level is known as a budgeted rate.
This month, we’ll take a closer look at the importance of budgeted rates and the concept of setting hedge ratios.
Understanding Budgeted Rates
Budgeted rates tie in directly with a key element of almost all foreign exchange hedging programs: protecting your profit margins. A budgeted rate represents the exchange rate at which you can profitably operate at your desired margins.
Once your budgeted rates are established, you can secure those rates with hedging contracts to ensure your profitability is protected. Understanding your budgeted rate is therefore crucial to achieving the goal of protecting your profit margins.
Establishing Budgeted Rates for your Business
An ideal time to consider your budgeted rate is when you identify and categorise your exposures. Not all budgeted rates are created equally. How these are established will differ significantly from business to business and exposure to exposure. The timeframe for which a budgeted rate is set will also vary greatly.
Ultimately, you need to calculate what the exchange rate needs to be for you to be profitable on that exposure. The key input in establishing your budgeted rate is your gross margin. This might be done on an annualised, seasonal, or even product by product basis. Your budgeted rate will typically tie in with the category of exposure you are managing.
Simply put, securing budgeted rates through hedging allows you to forget about potential foreign exchange rate movements and get on with what you do best. Or, as some put it, it helps you sleep at night.
Other Budgeted Rate Inputs
Your budgeted rate will likely depend on more than just your desired margin. Budgeted rates can be impacted by your customer’s expectations around pricing, the spot rate on the day, your own budgeting processes, the timeframe for an exposure, or the level of risk your business is willing to take.
Achieving a Budget Rate – What does it mean?
Achieving (or beating) a budgeted rate is a bit like being the unsung hero of your organisation. You have ensured the profitability of your operations despite wildly volatile exchange rates. There is usually little praise for achieving a budgeted rate, however, there are often plenty of issues if budgeted rates are not achieved.
By failing to achieve budgeted rates, you may be putting at risk your organisation’s profitability or financial position. Not only would you find the board of directors and shareholders are unhappy, but many downstream stakeholders might also be affected. Customers might have to suffer price increases. Employees variable remuneration might be impacted due to lower profitability. Other company initiatives might be cut as cashflow tightens. These are just some of the reasons why understanding the budgeted rate your business is working towards is so important.
FX Gains & FX Losses
Of course, there is always potential to outperform budgeted rates and secure FX gains. Secured FX gains increase the profitability of your business over budget. FX gains can help fund overperformance and enable your business to invest in other areas. FX losses, on the other hand, feed straight into the bottom line.
A good FX hedging strategy will allow for moderate FX gains to be accumulated over the financial year, providing a buffer for other shocks, and ensuring profitability for your main line of business.
Budget Rate Variations
When considering your budgeted rate, it may also be worth considering variations of such a rate. These might include:
- The Actual Budgeted Rate – the rate you look to achieve to ensure profitability goals are secured.
- The Target Rate – for those looking to pad profits or secure higher FX gains. Perhaps even incentives can be offered if these are achieved.
- The Zero Profit Rate – the rate at which margins are wiped out and you are instead focussed on preventing losses. There are other names for this rate that aren’t suitable for publishing. Dealing at this rate would be an unfortunate situation, usually the result of lack of planning and execution. This could include overhead costs, or not.
Bringing it All Together: An Example
An Australian furniture importer is gearing up for the summer season. They are looking at buying USD 12 million of furniture at a budgeted rate of 0.7200, and budget that sales will reach NZD 18.75 million. Their goal is for double-digit gross margins at 11%, with a stretch goal of 15% based on strategic hedging. Here are how the numbers look:
The key is, of course, that the budgeted rate of 0.7200 (or better) is secured through hedging contracts.