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
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!):
Sounds easy, right? Sometimes it can be – but there are some common pitfalls to avoid and more sophisticated approaches to explore
This is a variation on a call I have received far too frequently across my career.
The call comes in from a CFO:
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.
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:
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.
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.
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