It is human nature to want to see into the future and this is one reason why forecasts – I will refer to them as predictions from here on – are popular.
An experienced analyst can put together quite a compelling story as to why they feel their prediction will come to fruition.
In some cases they may be right but there is always a risk they can be wrong, there is one thing that’s for certain though – time will tell!
A murky crystal ball
I don’t intend to take a pot shot at currency prediction because it is an extremely difficult exercise, as there are a very large number of variables that can influence price.
But the main point is that predictions are made based on information known at the time and built on assumptions.
Of course both of these can and do change over time, hence so too do the predictions. For this reason it is dangerous for a business looking for certainty, and wishing to set budgets, price lists and plan costs, to make decisions based on currency predictions.
Needing some certainty
Having some certainty for businesses is vital as it can help plan for the future, reduce risk and lock in profit margins – all of which only serve to strengthen the bottom line.
Depending on the profile of your business you may have calculated an Internal Budgeted Exchange Rate (IBER) for the year ahead (AUD/USD parity seems to be a common one amongst importers at the moment).
One method used to calculate an IBER is to take an average of the forecast from four banks. This tends to satisfy business owners as it seems to be a logical yet independent method of forecasting future foreign currency cash flows in the local currency.
When the herd gets it wrong
One of the problems with this strategy, however, is that at certain times the general market consensus (the “herd”) can be wrong. And if the four banks all have similar forecasts on the same side of the market it poses a greater risk to future revenue for your business.
It’s all well and good to blame the currency market or forecasters for dropping revenue but it will be of little comfort to yourself. So should a business just not bother with an IBER?
The simple answer is no. Quite often it’s not the Internal Budgeted Exchange Rate that’s the problem but rather the lack of an appropriate FX hedging strategy. The smartest approach would be to align the IBER with the hedging strategy: i.e. work backwards.
For example, as an alternative to aligning the IBER with forecasts it is feasible for some businesses to instead use the 12 month AUD/USD forward exchange rate (FEC rate) as a guide. This is a much more tangible and realistic starting point as it is what is already known.
Let’s assume this works out to be an exchange rate of 1.0100. As a business you can then apply a margin on the rate before transferring this through to use as your IBER. So you could apply a 5% buffer and use 0.9600 as the IBER instead.
If suitable then you could take out a 12 month hedge at 1.0100 to cover foreign currency requirements and protect your profit margin and draw down from this hedge throughout the year to make your payments.
Of course this would then be used to translate through to your customers’ pricing, which raises the other important issue of your competitiveness.
Jim Vrondas is chief currency and payment strategist, Asia-Pacific, at OzForex, Australia’s leading international payments solution provider.