Just like everything else in life – from barbequing, to merging into traffic, to releasing new products during certain economic cycles – timing is absolutely crucial in hedging foreign exchange exposure. The best way to know when to hedge or not is by looking at a chart – yes, it’s that simple!
Take the NZDUSD pair from January 2003 to December 2009:
In April 2005, the NZDUSD moved to new all-time highs, having broken the previous one set over a year earlier. At this time, it wouldn’t have been wise to hedge against further new highs; but taking on a hedge for a downside risk would have been reasonable. The same can be said about the NZDUSD in January 2009 – it had moved to its lowest exchange rate in over six-years – it might not have been appropriate to hedge against further downside risks, but instead more proper to hedge against upside risks (hindsight being 20/20, this would have been a wise idea).
For example, in January 2008, it would have been a good time for a New Zealand company hedge payments made in U.S. Dollars, because were the NZDUSD to depreciate in value, the more money the firm would have to pay. If in January 2008, the New Zealand company decided not to hedge US$10 million in payments due a year later, it would have seen its cost rise from N$12.5 million (NZDUSD = 0.8000) to N$20 million (NZDUSD = 0.5000). By not hedging, the New Zealand firm would have had to pay out an extra N$7.5 million!
The next blog post will illustrate how market positioning can be used in timing.