Internal Hedging Methods & Techniques: Hedge FX Risk
Companies that trade in foreign currencies are at risk of changing exchange rates. For companies that export, currency fluctuations can cause profits to be reduced, and for companies that import, higher costs can be incurred. If a company wishes to reduce this risk, it is necessary for them to find a way of carrying out FX hedging.
FX hedging just refers to the process of following a method (or a strategy as it’s more commonly known) that helps a company to overcome the risk of exchange rate changes when they are trading in foreign currencies.
While it may seem to be a complicated subject, it is not actually that complicated. The basic premise is simple and that is that a company that carries out FX hedging is just finding a way to operate without being at risk of exchange rate changes. The main aim behind FX hedging is normally to provide certainty to a company in terms of what its profits or costs will be when trading internationally.
While it may seem obvious that any company trading in foreign currencies should adopt an FX hedging strategy, traditionally the process of carrying out FX hedging has been so complicated, time-consuming, and expensive that only the biggest businesses have been able to do it. This has been costly to small and medium-sized enterprises (SMEs). Currently….
Only 2% of SMEs protect themselves from currency risk. This compares to 92% of Fortune 500 companies.
The average currency loss for SMEs in the UK that trades in foreign currencies is £70,000.
Bound exists to simplify the process of FX hedging and to provide ways in which all businesses which trade in foreign currencies can adopt an FX hedging strategy, including small and medium-sized enterprises.
Internal and External FX Hedging
The two broad headings under which FX hedging strategies come are internal and external. Internal FX hedging is also known as passive hedging and external FX hedging is also known as active hedging.
Internal currency hedging strategies are strategies that companies can adopt using resources that are available to them within their business. This compares to external hedging strategies which usually mean dealing with a third party, outside of the business itself.
Internal methods of hedging FX are often cheaper and easier to implement. However, too many companies are unavailable, turn out to be a poor approach to business, or are actually more difficult to implement. Where a company is unable to carry out FX hedging internally, it will go to a third party to carry out external FX hedging. Bound is an example of a third party that is able to provide external FX hedging.
Internal FX Hedging Methods
Here are the most commonly used internal FX hedging methods.
Invoicing in Domestic Currency
An obvious and simple way that exporters can hedge FX is by invoicing their customers in their own currency. This removes all of the risks that the company would face if it traded in their customer’s currency. However, this passes on the risk to the company’s customers and could cause lost sales where customers are unwilling to take on this risk.
Entering Into a Risk Sharing Agreement
A business can enter into a risk-sharing agreement with a company located in a foreign currency zone with which it wishes to trade. The extent to which the risk is split can be negotiated, however, often two companies will agree to have an equal share. Any differences which arise due to exchange rate changes that happen between the date a sale is agreed and the date when payment is actually made is split down the middle.
Leading and Lagging
With leading and lagging a company will proactively look to either make or receive foreign currency payments at a time when exchange rates are favourable to them or at least don’t cause them a loss. For example, if an exporter expects that the currency in which they expect to receive a payment is set to weaken against their own, they will try to obtain payment quickly. They could do this, for example, by offering a discount for faster payment. Similarly, an importer would try to delay payment in the same situation.
Leading and lagging can be effective. However, it requires a certain amount of management and could cause a loss of sales where businesses in foreign currencies reject your approach. On top of this, there is also uncertainty with this approach as it is not always possible to accurately predict how exchange rates will change.
Exporters can, potentially, vary their prices in line with how they expect exchange rates to change between the time of sale and the time of payment. While this approach is possible, it is risky. Again, this is because it is difficult to predict how exchange rates will change. On top of this, making price variations can cause a loss of sales where prices become uncompetitive. Often this approach is only suitable for market-leading businesses.
Companies that both receive and make payments in one particular foreign currency can carry out matching. With matching the company will use the incoming payments it receives in the foreign currency to make the outgoing payments it needs to make in the same foreign currency. Some businesses will open a bank account in the foreign currency zone in order to handle transactions.
This removes the need to exchange the incoming money they receive into their domestic currency and then back into the foreign currency to make payments. Where this is done (without matching in the foreign currency zone) and a time lag occurs, exchange rate changes can cause money to be lost. Usually, while the majority of a transaction will not need to be hedged as it will be carried out in the foreign currency, there will be a surplus amount that can be hedged using a different method.
Many businesses and, in particular, many SMEs do nothing about the risk they face from exchange rate changes. The logic behind this approach is often that while exchange rates may change unfavourably one moment, the next moment they are likely to change favourably. The hope is that over time the net difference will be equal. Other businesses just ignore the issue of FX hedging because of the complications, time, and costs which are involved in carrying it out.
While some businesses may be able to do nothing about the risk they face from exchange rate changes, for others, this will not be possible. Predictability in cash flow is often key to the successful running of a business. Being uncertain about what payments a business will have to make in foreign currencies or what income they expect to receive can make it difficult to plan future business operations. Often, the main aim behind adopting an FX hedging strategy is to bring clarity to a business that trades in foreign currencies.
On top of this, there are other reasons why a business may wish to hedge their FX transactions. For example, businesses that find themselves carrying out an isolated large transaction in a foreign currency may not wish to take a risk with this particular transaction. This risk of suffering a loss of profit or a higher cost could be too high from an individual transaction, and this could encourage them to hedge this transaction. Businesses which operate in low-margin sectors are also likely to hedge FX transactions as small negative movements can stop them from making a profit altogether.
Is Internal FX Hedging the Right Approach?
Whether or not a company chooses to hedge its FX transactions internally depends on its circumstances. Any business which is seeking to adopt an FX hedging strategy will need to choose the approach which best protects their profits and prevents losses, but which still allows their business to operate effectively.
Some companies will find that one of the internal hedging methods mentioned above is appropriate to them, while others will find that internal FX hedging is not possible. Where internal hedging is not possible, a business will seek to follow an external FX hedging method instead.
External FX Hedging Methods
As we already mentioned, with external FX hedging a company will go to a third party which will provide them with a way of hedging their FX transactions. Usually, this third party will hedge FX transactions by providing a contractual agreement. There are a number of different types of contractual agreements available and they all have their strengths and weaknesses.
Bound is an example of a third party that provides external FX hedging to companies that trade in foreign currencies.
The most common ways of hedging FX transactions through an external third party are through forward trades and option trades. Spot trades are another tool used when exchanging foreign currencies as well.
Forwards trades allow a company to set an exchange rate with a third party for a future date.
For example, a company from the UK may take an order for $100,000 worth of merchandise from the US, but the buyer may not have to make the payment until a later date. This leaves them vulnerable to exchange rate changes. They can accept the order immediately, but by the time the buyer actually pays the dollar may have weakened. This would cause them to lose money.
If they take out a forward trade on the day they agree to the order, the provider of the forward trade (e.g. Bound, a broker, or a bank) could agree to exchange dollars to pounds at a set rate, but not until a later date. The set rate could be the current exchange rate when the forward trade is agreed upon. This agreement locks in the exchange rate. When the company receives the payment from the buyer, they take it to the third party which converts dollars back into pounds at the agreed rate. Without this agreement, they would be forced to exchange dollars for pounds at the market rate when the payment is received. The forward contract locks in an exchange rate and prevents the company from losing money due to exchange rate changes.
Forwards trades allow businesses to carry out transactions where payments are not made until some point in the future. Delayed payment can be received or made without changes to the exchange rate having an impact on the amount of domestic currency that is either received or paid out.
Option trades are similar to forward trades, except that there is no obligation to complete a transaction. With a forward trade, once it has been agreed to, a company that takes one out has an obligation to exchange money with the third party which provides the forward trade. With an option trade, the company has the right to back out and this brings certain advantages.
After taking out an option trade, a company is able (if it wants to) to exchange a set amount of money at a minimum rate and by a particular date. This is often done in anticipation of a deal occurring. Again, for example, a company may anticipate that it will have an order for $100,000 USD of merchandise and in preparation, they will take out an option trade.
There are three possible outcomes:
If the order does not come through, they can back out of the option trade.
If the order does come through and by the time payment is received exchange rates move unfavourably, using the option trade will prevent exchange rate changes from causing them to lose money. In this instance, the option trade works in the same way as a forward trade.
If the order does come through, but the exchange rate moves favourably the company can back out of the option trade and take a spot trade instead. A spot trade is just a normal currency exchange done at the normal market rate. Doing a spot trade, in this case, will allow the company to profit from the favourable change in exchange rates.
Spot trades are trades that are done on the spot, at the current exchange rate. Essentially, these are just normal currency exchanges. While in the context of an option trade they can be thought of as an FX hedging tool, spot trades are really the reason why FX hedging is needed.
Internal FX Hedging in Summary
Whether or not it is better for a company to follow an internal or an external FX hedging strategy depends on their structure and the market in which they operate. It is important, when beginning to deal with currency risk and when finding a suitable FX hedging strategy, to look at all of the options available and to find the most appropriate approach.
While it may be tempting to pursue an internal strategy, for simplicity and because they are often free, it is worth considering whether an external strategy could be more effective and a better choice. While there is a cost involved in external FX hedging methods, they are minimal. On top of this, they are often the strategies that allow the smoothest operation of a business.