Protecting the bottom line through currency hedging
7 min read
01 December 2014
Jonathan Pryor, head of FX dealing at Investec Corporate and Institutional Treasury, explains the finer points of currency hedging as a way to mitigate against fluctuations.
For any business operating in more than one jurisdiction or dependent on foreign customers or imports, currency risk is an ever-present threat to profitability.
With many firms, prices are set with reference to an exchange rate that can change by the time a contract is fulfilled and payments made. This can erode affect the bottom line in a number of ways: an appreciating home currency can push up export prices and reduce competitiveness for exporters, while the opposite is a headache for importers, who have to put up prices or take a hit on their margins.
The clearest risk is for importers and exporters but even for companies not directly involved in import or export business, any exposure to foreign markets carries an FX risk. Adverse currency moves can change the cost of goods and services necessary for the fulfilment of a contract, eroding profitability, and any firm taking revenues in foreign currency has to consider the exchange rate when repatriating that income to sterling.
Given all these factors, it is no surprise that a number of companies this year have had to restate their earnings forecasts, specifically because of currency risk. Thankfully, hedging offers a way to offset these risks.
A hedge is simply a transaction designed to offset the risks associated with other investments or exposures. On currency, the ultimate goal is to protect against adverse movements in foreign exchange rates, wherever you have exposure to foreign currencies and markets.
The most popular hedging product is a forward contract, allowing clients to buy or sell a currency at a predetermined rate. The easiest way to explain how these work is to give a practical example.
One of our clients is a manufacturer of industrial valves, which cost $1.5m to make and take 18 months from commission to delivery. It exports these to clients in the Middle East and Far East, which pay for them in dollars. The company obviously has to offer its customers a fixed price for its goods, but over 18 months the exchange rate between dollars and the pound could vary by as much as 10 per cent, potentially wiping out much of its profit should sterling weaken once the dollar revenue has been converted to sterling.
Given the sums involved, the need to purchase costly materials such as complex alloys and the fact that its cost base is in sterling, it is essential to the client’s profitability that the company receives what it expects to receive in pound sterling.
What can be offered is a forward contract per project, ensuring that dollars can be converted into sterling at a set rate when the goods are delivered and paid for. This is based on the rate of exchange between sterling and dollars at the time the contract is signed, giving the firm full confidence that its revenue from each project is as expected.
Of course the importance of hedging in this way varies from industry to industry and company to company. Fruit and travel, for example, are very price competitive industries and companies in those sectors will reset their exchange rates every couple of weeks.
This means that currency hedging is not necessarily as important for them as for retailers, which re-cost their exchange rates once a season. As these are typically autumn/winter and spring/summer, this means they might reset their rates just twice a year, leaving them vulnerable to six months’ worth of currency volatility. Getting that rate wrong would eat into their margins, bringing hedging centre-stage as a protection for their profitability.
While there is an argument that hedging removes a company’s ability to benefit from currency moves in its favour, the risks of not hedging are manifold.
Not only does it put profit margins at risk in the event that markets move the wrong way, staying unhedged can damage a business’s competitiveness if its competitors have invested in certainty on their foreign currency revenues.
Staying unhedged also creates uncertainty – never a good thing for a board or company officers responsible for managing risk and taking strategic decisions. This filters down to financial and commercial staff, whose jobs are much easier if they have a dependable set rate to work from when they make financial planning decisions or set commercial targets.
For firms anxious about missing out on currency moves that actually work in their favour given their particular business and currency mix, it is possible for them to hedge a percentage of their exposure with forward contracts and utilise a more flexible hedging product that will allow participation in a favourable market move.
This is not about “playing” the markets, but giving businesses the best chance of making their money work for them in the context of markets that can be intimidating for non-specialists.
It is important to remember that this is not speculation. For companies, hedging is not about predicting where the market is going, or arranging hedging exposure at the best possible time – although that can be an element, setting a rate when the market will ask for a low price for doing so.
Fundamentally, it is about protecting against adverse market moves. For a company with an international outlook, it’s as simple – and important – as taking out insurance or hiring an accountant.