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Hedging for Large ‘One-Off’ FX Exposures

Published January 30, 2020

Introduction

Maybe it’s finally time to upgrade that tired old equipment, and you’ve just had the capex budget approved. Or it might be that you’ve been awarded a large government project that has a significant portion of its cost base in a foreign currency. Perhaps your sales team have finally closed that large international sale they’d been working on the in US – but the customer has insisted on paying in US dollars instead of your home currency, the Australian dollar. Perhaps you’re buying a new business or selling part (or all!) of yours.

Whatever the scenario, many businesses face large one-off foreign exchange exposures – and managing the risk is not always straightforward. There might be a tender process to manage, where exchange rates can change from the time of bid to the time that currency is exchanged. There could be delays to previously agreed settlement time-frames, leaving you exposed to market fluctuation during that unplanned time. There are dozens of subtleties that can make or break effective FX hedging decisions. In this article we break down some of the key factors

Back to Basics

Before we look at the nuances of large one-off exposures, it is worth taking a quick refresher on the FX Hedging Cycle, which we have covered previously in more detail. The shorter, five-step summary is as follows – and going through this cycle is best done as soon as you know about your exposure (and not six months after the price was first offered!):

  1. Identify Risks. This includes assessing the potential currency impact on your large exposure. Some sensitivity analysis or stress testing is appropriate here.
  2. Set Objectives. Commonly, with large one-off exposures, the primary objective is to take all risk off the table and protect the value of the exposure.
  3. Plan. This is where you can keep it simple. Most businesses will adopt a back-to-back approach, where FX contracts are booked to match known project commitments.
  4. Execute. Here, businesses lock in exchange rates – the phrase ‘set and forget’ may ring true.
  5. Review. Periodically check your project is on track.

Sounds easy, right? Sometimes it can be – but there are some common pitfalls to avoid and more sophisticated approaches to explore

Pitfall #1: Agreeing to a Project Price Before Agreeing to an Exchange Rate

This is a variation on a call I have received far too frequently across my career. 

The call comes in from a CFO:

“Hi Phil, I wanted to chat about this large one-off exposure we have. We wrote the contract six-months ago and the client has finally agreed to the terms this week. Problem is, the exchange rate has moved 8% and is eating up most of our GP. Is there anything you can do?”

 

The only way to achieve the rates of old is to take a gamble. This might be by using an unhedged position (and hoping the exchange rate bounces back) or by adding risk through more sophisticated, enhanced-rate style products. Unfortunately, the best advice in this situation is often to bite the bullet, cut further losses, and lock in FX cover.

For this reason, the FX Hedging Cycle should be adopted and incorporated into the pricing and contractual stage of your project – or you could face similar issues.

Protecting Throughout the Tender Period

Avoiding the most common pitfall may not be easy (despite its importance). But an experienced consultant can help you navigate this process. Some common approaches include:
  • Adding a buffer – i.e. charging more up front to cover you in the event the exchange moves against you. This typically comes at the expense of competitiveness.
  • Contractual clauses – perhaps where a pre-determined percentage change in exchange rates across the tender period will trigger updated pricing.
  • Using vanilla options – i.e. an FX hedging instrument that gives you 100% protection against adverse currency movements at a known rate (with no obligation to exchange any currency) for a pre-determined premium (fee).
These decisions can be made easier with the help of your FX dealer’s advice. However, the fun doesn’t usually stop there.

Pitfall #2: Moving Goalposts; Expect the Unexpected

Great news! The contract has been signed and you can now begin your project. But that doesn’t stop the billionaire media mogul from wanting to add a helipad to her superyacht that you’re building. Or stop the new government from pulling the pin on the opposition’s exuberant infrastructure project that is already underway. Or guarantee that manufacturing partners meet all their quality control checks. Or even ensure that simple deadlines will be met.

It is common that large one-off exposures will change over time. Planning for these changes is important. Here are a few things to consider:

  • What are the possible scenarios for alterations, and what would the implication be for any FX hedging contracts you have put in place? For example:
    • Would it be as simple as a short extension to a contract? Would the contract rate change or incur fees?
    • Could it be more serious, where an entire FX contract would be closed out for a profit or a loss?
  • What is the likelihood of the goalposts being moved? Who would cover any costs?
  •  The same three items listed earlier can be useful: is it worth adding a buffer, including contractual clauses, or using vanilla options?

Using Vanilla Options

A tool used to protect large exposures which may or may not eventuate is a vanilla option. These give you – the purchaser of the option – the right (without obligation) to exchange currency. There is a non-refundable premium that must be paid by the purchaser of the option, but it gives the purchaser the ultimate in risk management tool: full protection, with the flexibility of having no commitment.

This cost of protection could be budgeted for during the process, and the flexibility on the option could potentially allow for additional FX gains if the exchange rate moves favourably. At the very least, a vanilla option should be considered during your planning stages.

Conclusion

Large one-off exposures to FX can sneak up on you if not identified and managed from the outset. The best thing you can do is to start the FX Risk Management Cycle early. Once you have a known commitment (even if that commitment is your requirement to honour a fixed price), you should have a plan in place – which may include a suitable FX buffer, contractual clauses, or smart hedging solutions. To learn more about this process, contact me today.

Phil Lynch
Corporate Hedging Director, APAC

Phone: +(64) 9 941 4052
Mobile: +(64) 21 516 826
Email:    plynch@encorefx.com

 

 

Adam Nikitins and Stewart McCallum were appointed Joint and Several Voluntary Administrators of EncoreFX (Australia) Pty Ltd on 30 March 2020.

Rees Logan, Adam Nikitins and Stewart McCallum were appointed Joint and Several Voluntary Administrators of EncoreFX (NZ) Limited on 30 March 2020.

Any queries regarding the Administrations should be directed to encorefx@au.ey.com.