What Is Hedging?
Volatility in the foreign exchange market can disrupt your cash flow, complicate your financial forecasting and erode your profits. Yet approximately 55% of SMEs in the UK do not hedge their exchange rate exposure at all.
‘Black Swan’ events such as the UK’s Brexit referendum and the US Presidential elections have highlighted how a failure to hedge currency risk properly can have a severe impact on a company’s growth prospects.
Once broken down into a formal hedging programme that determines when, how much and how far forward to hedge – the whole process becomes a lot less daunting.
The Common Mistake
Many SMEs who do hedge, fail to hedge properly. They will buy forwards erratically when they think the exchange rate is ‘favourable’ or ‘optimal’ with little or no structure. They will perhaps utilise currency forecasts and market commentary to inform their opinion. Consequently, when the hedges do not go in their favour the conclusion is often that ‘hedging is not for them’.
However, the reality is nobody can predict where the currency markets are going to go over the long term. Hedges that are grounded in a directional view of the currency markets are driven by either fear or greed.
Such an approach will often lead to an SME buying either too much or too little currency forwards at a rate that is not tied to their commercial objectives. This is known as ‘over-hedging’ and ‘under-hedging’ respectively. Executed poorly hedging can be just as damaging to a business as not hedging at all.
Hedging therefore works best when it is structured and ideally documented in a formal policy. Decisions should be grounded in a company’s commercial objectives first and foremost. When applied consistently and habitually a proper hedging programme can stabilise cash flows and ultimately enable business growth.
Formulating a Strategy – Your 6 Step Plan
1. Identify your exposure(s)
Do you have regular outgoings in the form of foreign denominated invoices? Are your profits derived in foreign currency? If you have both incoming and outgoings in the same foreign currency then what is your net exposure? You can broadly separate your exposures into 3 types:
Committed exposures – you can say with certainty when these exposures will materialise and how much they will be for.
Forecasted exposures – you can say with a degree of certainty when these exposures will materialise and how much they will be for.
Sporadic exposures – you can say with little or no certainty when these exposures will materialise and how much they will be for.
2. Set Your Budget rate
Most firms will set one budget exchange rate for the year or sometimes on a per project basis. This is the rate at which all foreign currency denominated cashflows will be benchmarked against. This rate must be set at a level at which you know your company will meet its earnings expectations for the year.
Be realistic when setting your budget rate. It should be relative to the current spot market but bear in mind forward pricing differs from spot pricing. Some companies use the previous years average rate for example.
This budget rate is now the rate which needs to be protected.
3. Determine Your Hedging Ratios
Now you know the type of exposures that you have and the rate you need to protect, you can now determine your hedging ratios. Ultimately, this will depend on your risk appetite but usually a larger proportion of committed exposures are hedged and a smaller proportion of forecasted exposures are hedged. Sporadic exposures are often left unhegded but kept under constant review.
4. Select the Right Tools
Forwards – lock in a a guaranteed exchange rate for a future date. These can be flexible (drawdown any amount and anytime before expiry) or fixed (drawdown the full amount on expiry).
Orders – Allow you to capture a market movement in your favour and/or protect you if it moves adversely against you. Orders are active 24/5 meaning that you don’t miss or get caught out when your focus and attention is rightly elsewhere.
Spot – purchase any unhedged exposures as and when they arise.
These tools can of course all be used in combination with one other.
Once you have determined your budget rate, hedging ratios and the tools you wish to use it should then be documented and adopted as company policy.
This policy should be signed off by all relevant decision makers to ensure that everyone in the business is aligned.
6. Execute and Adjust
Now you have a formalised hedging programme and a policy in place, it is time to execute it.
Revisit and optimise your strategy to ensure that your commercial objectives continued to be met. However, ensure that policy drives your decision making process not the currency markets.