A look at how FX hedging can help you mitigate foreign currency risk
Global currency markets have been experiencing larger than normal swings of late and with greater frequency, CFOs are citing foreign exchange volatility as a factor when companies miss their earnings targets. Increasingly, business leaders are looking to implement hedging programs to mitigate foreign exchange rate risk and create more certainty and stability within their organizations.
“For global businesses, the hedging of foreign denominated cash flows is vital to avoiding earnings swings,” says William R. Schumaker, vice president and foreign exchange advisor in International Banking at Bridge Bank. “Companies that maintain ineffective hedging programs, or those that do not hedge at all, unnecessarily expose themselves to financial risk.”
Foreign exchange (FX) hedging gives treasurers the ability to protect cash flow and profits by locking in certain rates of exchange. This is done for balance sheet items such as payables and receivables, as well as cash flow items such as forecasted sales and expenses.
Smart Business spoke with Schumaker about some of the key components of a successful hedging program.
Which tools can companies use as part of a hedging program?
Working closely with a trusted banking partner, an organization can easily gain access to the necessary and appropriate hedging tools available in the marketplace to mitigate their currency risk. There are myriad FX hedging instruments which can be employed to lessen foreign exchange rate risk, from basic FX spot transactions to range binary options. But you don’t need a sledgehammer to kill a gnat; future foreign currency exposures can be effectively managed with a simple FX forward contract. It is essentially the same as a standard spot trade, except that instead of the deal settling and funds being made available in two business days, settlement can be pushed forward to a predetermined future date of the customer’s choosing and with an exchange rate locked in.
This will protect company margins from unfavorable variations in the currency exchange rate from inception to settlement date. The price of the forward versus spot is adjusted marginally, accounting for the interest rate differential between the currencies involved given the duration.
With the nominal rate differentials between the U.S. and, for example, Europe, Canada or Great Britain, forward hedging costs in these currencies are relatively flat. A variation of the standard forward is the ‘window forward’ contract. Offering more flexibility, the window forward allows the holder to choose a ‘window’ of time in which to execute a future foreign currency conversion. This tool can be particularly helpful when you have expected cash flows with nonspecific settlement dates.
What hedging strategies are used by global companies?
Many companies choose to execute all of their hedging for the entire year in one fell swoop prior to the beginning of their fiscal year. While this static hedging strategy provides companies the opportunity to set budget rates for the year, it is also limiting. The practice of establishing cash flow hedges at the start of the year lacks flexibility as opportunities to react to FX forecast changes and favorable market entry points are largely lost.
A better method is often the layering of hedges. This dynamic approach realizes the correlation between time and risk; with longer dated exposures carrying a greater degree of uncertainty with respect to exchange rates. As an example, one might consider hedging shorter term commitments, perhaps out to six months, at 100 percent while commitments from six months to one year may have a hedge ratio of 75 percent and exposures beyond a year could be treated with yet a lower hedge ratio.
As time progresses, hedges can be adjusted to fit their appropriate ratio for the new time period. No matter how you implement it, this ‘rolling’ hedge structure should see more stable hedge results and provide a smoothing effect on forward hedge rates over time versus a single hedging event.
These are but a few key hedging concepts. The areas of netting, derivative accounting and effectiveness testing are important topics which demand attention. Nevertheless, it’s certainly worthwhile to consider developing a hedging program to protect against adverse FX movements.
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