The Benefits of Hedging, and Managing FX Risk: Part 2

Managing this FX risk faced by importers and exporters all over the globe today is a three-step process: identify FX risk; develop a strategy; and utilized the proper instruments/strategies to hedge the risk.

Identify FX Risk

As explained in the previous blog post, the most common type of risk faced by firms is transaction risk. For a New Zealand exporting company paid in Australian Dollars, measuring FX risk entails determining how many Australian Dollars it expects to receive over the coming quarter (whatever the period of business may be), versus the money the New Zealand firm will need to make payments in Australian Dollars over the same period. Simply put, this difference is the amount that needs to be hedged.

Developing a Strategy

Developing a hedging strategy necessitates that the following questions be answered: when should FX exposure be hedged; what tools/instruments are available under the current circumstances; and how will the performance of the hedge be measured? Developing a strategy is contingent on where in the process a firm is (see flow chart below).

Blog 5 Image

Using the Proper Hedging Instrument

Implementing the proper hedging strategy involves a review of the company’s policies as well as the intentions of the hedge. Hedges can vary from something simple like purchasing the foreign currency, to more round about ways like purchasing commodities in the country where the company’s products are sold.

We will discuss different types of hedges – what the proper hedging instrument is – in the next post.

The Benefits of Hedging, and Managing FX Risk: Part 1

Many small- and medium-sized firms engaging in import and/or export activity tend not to hedge. The reasons not to hedge come in all shapes and sizes: it’s too complex; it’s too costly; there’s a misconception that it is speculation; or even that that firms don’t know about hedging tools and strategies available to them. And in the case that companies don’t hedge despite being aware of its benefits – the excuse is often that exchange rates might even hold steady! These are costly, misguided beliefs!

Many studies show that hedging is a necessary activity for firms operating in the contemporary globalized economy. Benefits include:

– Increase ability to forecast future cash flows

– Minimize the impact of exchange rate volatility on profits

– Diminish the need to attempt to forecast exchange rates

– Helps ‘buy time’ for a company to adjust its marketing and sales strategies should the domestic currency rise in value, thereby reducing the firm’s competiveness abroad

Needless to say, if a firm has the financial ability to hedge at a reasonable cost, there’s no reason not to! Essentially, hedging is like FX insurance.

The next blog post will cover the steps involved with hedging.

Explaining Different Types of Exposure Risk

Importers and exporters alike face foreign exchange risk, or currency risk, when engaging in economic activity outside of their domestic currency. As explained in an earlier blog post, currency risk materializes for exporters when exchange rate volatility results in the company repatriating fewer revenues abroad, when the domestic currency strengthens relative to the foreign currency. For importers, this risk is the exact opposite: currency risk materializes when the domestic currency weakens relative to the foreign currency.

When shifts in foreign exchange rates are not hedged against, firms unnecessarily take on transaction exposure, or FX risk that negatively impacts cash flows. Typically, small- and medium-sized firms do not hedge against transaction exposure, despite the negative impacts it may have on profitability. Consider the FX relationship between two closely knit economies, Australia and New Zealand: the AUDNZD exchange rate has been as high as 1.3277 (December 2011) and as low as 1.2370 (October 2012) over the past year.

blog 2 image

This exchange rate volatility demonstrates why hedging is necessary. Let’s say that a New Zealand firm sold A$100,000 worth of product in Australia in April 2012, when the AUDNZD traded at 1.2600. Given the exchange rate, the New Zealand firm would expect to receive N$79,365 in return. However, if hedging wasn’t utilized, and the New Zealand firm repatriated its funds in July 2012 when the AUDNZD traded at 1.2950, it would only receive N$77,519 in return. By not hedging, the New Zealand firm cost itself N$1,846.

There are two other main types of currency risk posed to importers and exporters: accounting exposure and economic exposure. Accounting exposure comes about when firms have liabilities overseas, and must convert the foreign denominated liabilities back into the domestic currency. Unless exchange rates remain stable (a less common occurrence over the past few years), the liability conversion results in either gains or losses. Economic exposure tends to be limited to firms only operating domestically. For example, if a New Zealand firm only sells at home, but the New Zealand Dollar gains in value, consumers might look to competitors overseas given increased purchasing power; despite not being a participant in international markets, the shift in exchange rates could still have a negative impact on business.

The next post will discuss why it is thus important to hedge, and what the necessary steps are for a company to manage its foreign exchange risk.