Currency swings impact a company's foreign operations' cost competitiveness, profitability, and valuation. Although many businesses are aware of currency risk and its negative consequences, many fail to develop a Foreign Exchange (FX) Risk Management Strategy, leaving them unable to mitigate the possible negative implications of currency swings.
What is Foreign Exchange Hedging?
Businesses use hedging to manage their currency exposure. When a company wants to buy or sell one currency for another, it is vulnerable to swings in the foreign exchange market, which can impact their expenses (or revenues) and, ultimately, their profit.
Businesses safeguard an exchange rate against a given sum for a specified timeframe by booking a hedge, providing them with a measure of certainty.
Several hedging tactics and products may be employed, and it all relies on the business's goal and the risk it is attempting to protect.
Types of Foreign Exchange Risk
Companies face three forms of foreign exchange vulnerability: transaction exposure, translation exposure, and economic (or operational) exposure. We'll go through these in more depth below.
This is the most basic type of foreign currency exposure and, as the name implies, develops due to a real-world commercial transaction in foreign currency. The exposure happens, for example, as a result of the time lag between a customer's entitlement to receive cash and the actual physical receipt of the cash, or, in the case of a payable, the time lag between placing the purchase order and settling the invoice.
When a company has operations in foreign currency and reports its financial results in local currency, it is exposed to the impact of exchange rate changes on foreign currency transactions and the translation of all foreign currency financial statements into the reporting currency.
In order to present comparative financial information, a company must translate the revenues, expenses, assets, and liabilities of foreign operations from the reporting currency (local currency) into the currency of the entity's home country (i.e., in which the consolidated financial statements are prepared). This is done at the exchange rate that exists at the time of conversion, not at the rate that existed when the relevant transactions were made.
Economic (or operational) Exposure
This final form of foreign exchange exposure is long-term in character and results from the impact of unanticipated and inevitable currency swings on a company's future cash flows and market value. This sort of vulnerability can have a long-term influence on strategic decisions like where to invest in manufacturing capacity.
Economic exposure is broader than currency risk because it covers the risk of all assets and liabilities, not just foreign currency denominated assets and liabilities. It can be extremely complex to evaluate and control.
How to Quantify Your Foreign Exchange Risk
The first step in managing foreign exchange risk is to quantify it. Is it material? Will it be detrimental to my company or investors? Value at Risk (VaR) is one of the most used measurements. VaR is appealing since it is simple to grasp. Essentially, it raises the simple question, "How terrible can things get?".
In other words, the VaR expresses the highest probable loss at a given degree of confidence. For example, a VaR of 3,000,000 pounds suggests that your losses will not exceed that amount 90% of the time in a one-month period.
How to Calculate VaR
Value at Risk (VaR) is a financial statistic that evaluates an investment's risk. VaR is a statistical approach used to calculate the amount of potential loss that might occur in an investment portfolio over a specific period. The likelihood of losing more than a certain amount in a particular portfolio is expressed as Value at Risk.
Assuming that market returns are normally distributed, you may determine your VaR by using the volatility of past market returns. One typical method for estimating VaR is historical simulation. It entails using historical data to predict what will happen in the future.
Using Microsoft Excel:
Fill up the blanks with daily historical spot values.
Calculate the log returns in the next column (which will help normalise the data).
To calculate the standard deviation (= volatility), use the Excel function stdev(log returns).
By multiplying this daily volatility by sqrt, you may convert it to monthly volatility (21).
Finally, using the Excel function normsinv(90 per cent), determine the number of standard deviations of the desired confidence and multiply by the volatility and exposure size.
Hedging Foreign Exchange Risk
In order to reduce the effect of currency exposure, companies can use a variety of hedging instruments, including forward contracts, currency options and currency swaps.
1. Forward Contracts
In the case of a forward contract, the parties agree to exchange two different currencies at a set price on a forward date. A "sell forward" contract represents a binding agreement to sell a currency in the future at a predetermined exchange rate. A "buy forward" contract is an agreement to buy a currency in the future at a predetermined exchange rate. In both cases, the payment is made at the forward date, not at the spot date.
A "sell forward" contract has the same value as an "investment in the foreign currency" with an appropriate interest rate added to the spot rate. A "buy forward" contract has the same value as an "investment in the foreign currency" with an appropriate interest rate subtracted from the spot rate.
2. Currency Options
A currency option is a contract that gives the buyer the right, but not the obligation, to exchange currencies at a specified rate. A currency option is essentially a contract for the future delivery of a foreign currency.
There are two main types of options: a call option and a put option. A call option is a contract that gives the holder the right to buy a currency at an exchange rate specified in the option contract. A put option is a contract that gives the holder the right to sell a currency at an exchange rate specified in the option contract.
Although options allow flexibility, the option premium must be factored in. When purchasing an option to hedge an offshore investment, investors must get two things perfect. The investor must make a strong initial investment that yields a profit.
However, the investor must also be able to foresee the currency exchange rate for it to move in a favourable enough direction to cover the option premium. Although forwards do not allow the flexibility of walking away like options, they do lower the danger of a currency exchange loss and eliminate the need for investors to engage in currency forecasting.
3. Currency Swaps
Currency swaps are transactions similar to forward transactions except that the parties are replacing their cash inflows and outflows with cash inflows and outflows in different currencies. A simple example of a currency swap is when a company borrows dollars to fund a project and swaps the dollars for local currency to pay for the project. The company then swaps the local currency back for dollars at the end of the project, and the borrowed dollars are paid back in the original currency.
Although they're not perfect and have several disadvantages, forward and swap contracts are a valuable hedging tool and can be used by both companies and investors to protect themselves against the risk of exchange rate movements.
Currency options are a common way of gaining leverage on foreign exchange risk. Hedging with these instruments requires a great deal of currency risk knowledge and expertise to be deployed properly, and successful risk management shouldn't be attempted without assistance from a specialist.
Calculating the Cost of an FX Strategy
When addressing hedging costs, we must distinguish between hedging impact and trading costs.
In this case, we're talking about the cost of the interest rate differential (or, more simply, forward points), which might result in either a carry cost or a credit at the start of the hedge.
For example, when both currencies are major (e.g., GBP, USD, EUR, CAD, AUD, NZD, CHF), using forwards is virtually free. Forward points are presently nearly non-existent. If one or both of the currencies is from an emerging market (e.g., BRL, INR, MXN), the yearly cost might exceed 8%.
The bid-ask spread obtained by the counterparty or financial institution on the opposite side of the deal is referred to as trading charges. For example, when entering into a forward contract, you must ensure that both the spot rate and the forward points or interest rate differential between the two currencies are suitably priced.
It is important to note that it is the spread, not the forward point, that you will pay. This is because the forward point is included in the price of the underlying currency. You will not pay for the forward point but for the currency. Credit spreads are typically higher than the corresponding interest rate difference. Furthermore, you will also be charged a margin (typically around 1.5%) for the currency you purchase from the counterparty.
The Five Most Common Mistakes to Avoid
1. Failure to Use Hedging Instruments
When addressing an offshore investment, investors must always be aware of the exchange rate. As foreign exchange markets are the most liquid and transparent markets in the world, an investor can typically purchase and sell the desired currency at the current price, but the investor may need to wait for a period of time before doing so. This can result in an immediate loss and impact an investor's financial position if hedging does not occur.
2. Inadequately Structured Hedging Strategy
Many organisations' reluctance to implement a formal, written hedging policy is reasonable, given the need to remain flexible while managing risk in turbulent FX markets, and formal hedging policies may be perceived as burdensome and bureaucratic. However, the absence of a defined (and recorded) business FX hedging policy can be hazardous for a variety of reasons, including:
There is less organisation and discipline in the currency hedging process.
When conveying the hedging strategy to key stakeholders, there is a lack of openness.
3. Using Complex Derivatives as Hedging Instruments
The use of unsuitable hedging products is undoubtedly one of the most significant and hazardous errors related to FX hedging. Many corporations, in an attempt to cut FX hedging costs, end up with a portfolio consisting of sophisticated (and sometimes harmful) products and features, such as higher leverage, extensions, and barrier alternatives such as 'knock-outs.' Such characteristics are especially common in so-called 'zero cost' structures, and they can have a variety of unfavourable implications, such as over-hedging of underlying positions and losing protection when it is most required.
4. Failure to Consider Internal Risk Reduction Opportunities
Many companies use various FX hedging products but neglect internal risk reduction opportunities, such as purchasing a company's own currency in advance (and even at a discount) as part of the hedging policy. This strategy can be used instead of purchasing the currency at the time of settlement or before the settlement date. This can reduce the cost of the hedge and increase the company's immediate cash position.
5. Failure to Track the Overall Success of FX Hedging
Although FX hedging is one of the most complicated areas of risk management, it is also one of the most important. It is vital that the organisation's tracking of the impact of hedging activities is rigorous, as poorly documented or managed hedging strategies will have a negative impact on the company's financial position.
Companies that do not carefully monitor their strategies run the risk of:
Over-hedging their portfolio of assets and/or liabilities,
Losing protection when it is most required,
Overpaying for foreign currency denomination.
Foreign exchange risk management is crucial for any corporate forex risk management program. Devising a comprehensive risk management strategy and putting it into practice takes time and effort, but the rewards will last for years and will make all the difference for the success of your company.
Bound is a specialist foreign exchange hedging firm that offers currency protection for businesses.
We help companies that are at risk of losing money to changes in the exchange rate to protect themselves against these losses.
By using the services that Bound provides, UK companies of all sizes are able to conduct business in foreign currencies with complete certainty about the exchange rates that they will receive. Subscribe to our newsletter or watch a demo of our product today!