Hedging Currency Risk
Currency risk is a natural by product of trading overseas. In most cases, a company trading overseas will have to make purchases in foreign currency to pay suppliers or convert the receivable currency into Euros to pay overheads.
Given the volatility in foreign exchange rates and the credit timeline most companies will have to make a call on whether they hedge the currency risk or just convert to or from Euros on the day they receive the foreign currency.
The payment timeline can vary from a couple of weeks to a couple of months – a cursory look at Euro/US Dollar graph below which shows where the currency has traded over the last 3 months, makes it clear that if you are trading overseas you are likely be exposed to considerable FX volatility Source: Bloomberg Source: Bloomberg The Euro/ US dollar has seen a high of over 1.1600 down to a low of below 1.0900 in this period. In Euro terms, €100k could either have bought you $116k or $109k in this 3 month horizon – that’s a difference of €5k which could be the company’s profit margin.
So when Banks talk about currency hedging they usually mean using foreign exchange forward contracts to lock in today’s exchange rate for delivery on a date in the future. The date in the future can vary from 3 days forward to years in the future depending on the size and type of company but typically it’s not longer than 12 months.
Foreign Exchange Forward Contracts
One of the advantages of using foreign exchange forward contracts is that it buys certainty on the currency front. The company will know exactly how much they need to pay in their home currency or how much they will receive in their home currency when entering into a transaction. It allows them to protect their margin and removes the risk of being a hostage to volatile currency markets. What it doesn’t allow is taking advantage of any further up side in the currencies once the contract is booked.
Some firms may be willing to risk part of their FX exposure in the pursuit of a better exchange rate while others accept that the principle of protecting the bottom line is their priority. In reality, a company might not hedge 100% of their exposure but this is very much down to the risk appetite of the company in question and what their treasury policy guides.
In my experience, the one certainty when dealing with foreign currencies is volatility. As a company trading internationally the choices are around how you deal with this volatility in your business model. Do you leave currency conversion to chance and take the rate on the day or do you take a more proactive approach to managing the risk using forward hedging as a means to protect your bottom line? Expanding into new markets and taking on new suppliers overseas has many risks not just those in relation to foreign currency volatility – recognising and making a decision on how best to address those risks is half the battle.