Foreign exchange (FX) markets are exceptionally volatile, as anyone in the import/export business will tell you.
FX risk management is a reality that cannot be ignored. This is even true for companies like Proctor & Gamble, Coca Cola and Adidas, all of whom recently announced that the strong US$ (and weak emerging market [EM] currencies) had weighed heavily on their earnings. In fact, Proctor & Gamble noted that exposure to FX is expected to reduce their sales growth by 2-3 per cent for the year. That is a real loss (rather than an opportunity loss) and one that could have been avoided.
For any company that trades goods and services internationally, managing foreign exchange is not just prudent, it is necessary.
There are a variety of methods businesses can use to limit currency risk:
- Currency Forwards
- Currency Options
- Interest Rate Currency Swaps.
The second and third options can be complicated and are leveraged, meaning your losses can be exponential. For a company that relies on being financially prudent, I would suggest that unless you fully understand how these instruments work, you should stay away from them.
Having said that, if you buy a currency option your losses are limited to the amount of premium you spent to buy the option. However, if you sell an option your losses can be unlimited.
That leaves companies with only one easy to use and understandable option and that is using Currency Forwards.
Simply put, if you buy a forward outright, the rate you set at the beginning is the rate you exchange your currency at on settlement date.
For example: if you buy GBP against US$ for say 1 July 2015 (3 months forward) at 1.4760 (spot currently 1.4770) then, come 1 July 2015, you will sell your US$ and buy your GBP at 1.4760 (US$100,000 = £67,750.68). If, for example, the inter-bank spot market for GBP/US$ on 1 July 2015 is 1.5000 you will have made an opportunity profit of £1,084.01 ($100,000 / 1.5000=£66,666.67) because you bought your GBP at 1.4760 rather than on the day at 1.5000.
However, the opposite also holds true if the inter-bank FX rate for GBP/US$ was 1.4500 on settlement date. In this case you will have made an opportunity loss of £1,214.84 ($100,000 / 1.4500 = £68,965.52) because instead of buying at 1.4500 on 1 July, you are buying your GBP at 1.4760.
In other words, a FX forward is a contractual agreement to buy or sell currency at a fixed rate on a fixed date.
Please note that when you purchase forward contracts you will be required to post an initial margin payment (this can range from 5 – 20 per cent). You can think of this as a deposit of cash, which is held in trust for you.
The reason for this is that over the life of the contract there could be times where the position is loss making and the margin deposit will be used to cover that. Once the contract matures, that deposit will used as part of your financial obligation to settle the foreign exchange trade.
During the life of the FX hedge
Despite having a fixed FX forward contract you are still able to “unwind” this contract at any time before the settlement date (do the opposing trade to your original trade – this leaves you with either a profit or loss on the settlement date), AND also “draw down” on your funds.
In other words, if you fixed the contract to sell US$100,000 and buy GBP for 1 July 2015 and say on 14 May you needed to sell $50,000 of the total, that is entirely possible. By drawing down early it means that on final settlement on 1 July 2015 you will only have to execute the remaining US$50,000.
Bear in mind there are cash flow implications with an early draw down because the rates will be different and the average on the final settlement will change.
Global risks to consider when hedging FX
As your business grows and you become more and more global, you must take care to factor in all the necessary risks of globalisation. FX risk, as I mentioned above, is one of those factors.
So what are the things you should consider when dealing in FX?
- The interest rate deferential between the two currencies
- The volatility of the currencies
- Fundamental risks (earthquakes, floods, hurricanes, inflation, unemployment and war)
- Economic risks (CPI, GDP, PMI, Retail Sales, Interest Rate decisions)
- Commissions and costs related to transfer of funds
- The FX rate itself
- A change in official policy by the Central Bank
So many people, through no fault of their own, simply ignore these issues to their detriment.
There will always be pitfalls when trading internationally. It is the fact of doing business globally that you will be subject to the volatilities encountered in the FX markets. No business is immune to currency fluctuations, be they up or down.
However, as long as you are able to take the necessary steps to manage your exposure to foreign exchange markets, the volatility can be mitigated and even work to your benefit.
I hope this information helps you to develop the best strategy for managing your foreign exchange needs.
David Rosenberg is joint CEO for ParityFX Plc, a financial services company that focuses primarily on executing foreign currency transactions, providing structured FX solutions and currency advice. David has over 20 years’ experience trading in the financial markets, primarily as a risk-market maker on the FX and Precious Metals Options desk at institutions like JP Morgan, Lehman Brothers and Unicredit Banking Group . He also writes a daily blog on the ParityFX web site on foreign exchange news and advice relevant to SMEs.
Topics: Currency Exchange