Whether facing fixed or fluid costs, smart businesses will recognise the challenges posed by FX risk and deploy an appropriate strategy (company policy) to offset the risks judged as most threatening.
These are seven key considerations that we recommend when building your FX hedging strategy. The business should ask itself a series of questions in order to assist in an overall strategy that fits:
1. Identify what FX risk means for your business
What are the causes of the underlying FX risk (e.g. cashflow mismatch)? What are the impacts and sensitivities? How fine are operating margins and what is the risk of them being eroded by FX fluctuations? Is there an internal budgeted exchange rate and, if so, how is it calculated?
2. Consider ways of removing FX risk from the start
Is there a simple change in process that can help remove or minimise the FX risk e.g. aligning the customer billing cycle with your supplier payments?
Be careful though not to create other issues. It is quite common for some businesses to move to AUD pricing with suppliers or customers (if possible) to remove the impact of FX risk on their business. Whilst this may appear a sound strategy in essence it shifts the risk to the other party, in which case it could become more costly for your own business by negating some of the benefit.
3. Don’t speculate
Remove the guesswork. Make a plan. Commit to it in writing.
4. Set out clear risk management objectives
What is the ultimate attitude/culture of the business (from the top down) towards risk? Is it conservative or aggressive towards risk in general? Are there banking covenants that need protecting? What other issues need addressing?
5. Seek professional assistance from the marketplace
Do you have the necessary skillset within the business to formulate a strategy and manage ongoing risk? If not, seek to outsource this function or at the minimum serve to educate staff.
6. Regularly review hedging performance
Make sure you commit to regularly review any hedging against your expectations/policy (quarterly, semi-annual or annual). Do not judge performance solely by the “opportunity cost” of implementing appropriate risk management framework (very common). Consider any changes within the framework of your business that may need to be reflected in the policy over time.
7. Diversify your risk
Consider blending a number of different strategies. For example, a mix of spot and forward contracts or spot, forward and options. This can overly complicate things; however, some dynamic/fine margin business models may require such diversification.
It’s rare for an FX hedging strategy to give absolute protection nor do they come at a true zero cost. Crystal balls and silver bullets, sadly, don’t exist!
Picking up extra margin or profiting from favourable exchange rate movements through “dumb luck” can set a dangerous precedent. An active decision not to hedge is a valid approach but still worth documenting and reviewing the validity regularly.
But a business which recognises both the benefits and limitations of FX hedging will be the most effective at forming strategies.
Jim Vrondas is chief currency and payment strategist, Asia-Pacific, at OzForex, Australia’s leading international payments solution provider.