How to successfully implement a currency hedging strategy

By Vivek Savani, Executive Director, iBanFirst UK 

Identifying risks of changes in currency exchange rates

Although every company has its own variation of a risk management strategy, the common issue they share is susceptibility to unpredictable changes in currency exchange rates. The first steps a business must take in managing and reducing risk and overheads around FX is to divide and list their assets. This action will create an opportunity to plan a budget forecast and assess the risk of exposure of their business to changes within the foreign currency markets.

Companies with limited involvement in foreign currency transactions are not faced with the priority of analysing their level of risk for exposure to foreign exchange. On the other hand, companies that have profit margins reliant on the foreign exchange market must identify appropriate solutions as a matter of absolute priority. Listing all foreign currency assets including receivables, bank accounts, financial investments and any foreign currency debts, including accounts payable and loans will provide a clear picture of their existing situation.

Budget forecasting is an effective way to identify and gauge the most subtle exposures to risk from the foreign exchange market. Once the company has considered the pricing structure of products and/or services provided, they will be in a position to anticipate projection of cash in-flow and out-flow throughout the year. The average exchange rate used by businesses to convert currencies throughout the year allows them to establish a ‘budget rate’ to work with.

Strategic planning to avoid loss of revenue

Businesses can identify appropriate hedging strategies by first auditing and identifying foreign exchange risks. Once they have done so, the strategies can be created according to commercial margins, degree of risk aversion and financial products budgets. The options available will include an immediate locking in of the exchange rate of foreign currency transactions either as a whole or just a portion of the transaction. These actions would involve a systematic risk hedging strategy for the whole transaction option and a selective risk hedging strategy for the portion approach. It is imperative that the strategic plan is bespoke to the businesses’ needs and situation.

Exposure to various foreign exchanges can create a “natural hedge” with countering effects. It must be noted that businesses prioritise hedging just the main net exposure to avoid “over hedging”.

Financial products – finding the right fit for business

There are a variety of financial products available of differing levels of quality, features and with the ability to meet businesses’ needs to help secure foreign exchange rates around the framework of hedging strategies. There is a caveat, however, that businesses can choose the wrong financial products leading to a loss and should therefore give due consideration to evaluating the way in which these products operate and their related cost. By doing so, there will be an informed perspective on how the product(s) may have value in minimising risk to business. Employing a third party expert to give them a clear understanding of the functional compatibility of the product prior to any committed investment would be beneficial.

Consideration must be given by companies in selecting the appropriate financial tools according to factors including risk appetite, available cash flow, price budget and exchange rate policy. Those companies who lock in transactions at a set exchange rate are likely to favour traditional forward contracts, whereas those businesses who choose not to lock in are more likely to benefit from the leeway of flexible or dynamic forward contracts. Most companies’ needs are suited by derivative financial products including forwards, flexible and dynamic forwards, which are a viable first choice for most companies’ needs.

Measuring success

Overseeing strategic objectives and risks of exposure on an ongoing basis will allow the business to re-evaluate and assess in a pragmatic and informed manner as business needs and foreign exchange are subject to daily change. Reviewing the weighted average exchange rate regularly and comparing it with the set “budget rate” while monitoring changes in gains and losses in all exchange rates will prevent additional issues. These actions will allow the company’s hedging strategy to remain current and adjustable to future forecasts. A crucial factor in the success of a currency hedging strategy requires regular monitoring and management of risk strategies.

There are four main stages to consider for a successful hedging strategy. Taking stock of the company’s international financial situation, choosing the best strategic approach for business, identifying corresponding financial products and monitoring and modifying the strategy, as necessary.

In evaluating the outcomes of the hedging strategy, bear in mind that the priority is to maintain and protect the financial health of the business by buffering any impacts of market fluctuations. Therefore, it is essential that focus is set on business trading margins stability, guaranteed by the hedge strategy, rather than gains obtained from foreign exchange.