Currency hedging is critical: it affects both importers and exporters. During the global financial crisis, when the Australian dollar plunged around 40% in just five months, importers would have seen their costs for supplies jump 40%, just on the currency drop alone. Exporters would see overseas revenues plunge by the same amount.
But someone who was hedged during that period could have saved themselves paying that extra money. Hedging is a way to manage risk and lock in profit margins that can give a business a competitive advantage.
Types of hedging
The simplest way to hedge is by using a back-to-back forward exchange contract, which covers you for just the amount you need.
For example, if you know today that you’re going to pay $US20,000 to your supplier in China in three months, rather than speculate what the rate will be by then, you buy a forward contract to avoid any ugly surprises.
There are also products such as options to cover your risk. For example, a business may decide that they can’t afford an exchange rate of less than parity. So they buy an option that guarantees a rate of parity in three months. With an option, you have a right not to exercise it if the rate isn’t favourable that the time.
If you’ve got two-way exposure, and are paying foreign currency (to suppliers) but are also receiving foreign currency (from international clients), it’s best to net those off against each other to minimise your risks. That puts an element of natural hedging in place.
How to start hedging
Begin by talking with your bank. Even if your relationship manager isn’t an expert on foreign exchange, they can point you to someone else in the bank who can advise.
However, banks usually only offer hedging services to large corporate institutions. So smaller businesses may need to shop around to get the product or service they are after.
Then you need to decide how far forward you should hedge. Most people don’t do more than 12 months out. The most popular window is probably around the three-month mark, but it depends on the timing of your exposures.
If you have shorter time frames with your suppliers, it would make sense to match that timeline to your hedging.
Jim Vrondas is chief currency and payment strategist, Asia-Pacific, at OzForex, Australia’s leading international payments solution provider.