Small businesses can protect themselves from foreign exchange volatility by following a few simple rules. Take heed of this expert advice.
Global currency markets are the largest and most liquid of all asset classes, with average daily turnover estimated to be close to USD 4.0 trillion. Since the global economic crisis, foreign exchange (FX) markets have seen an increase in both spot and forward transactions, reflecting the increase in market volatility.
The Australian dollar (AUD) has seen its daily trading volumes soar: it’s currently the fifth most traded currency in the world. With major global economies in recession, and near-zero interest rates in the UK, EU and US, the Australian dollar is an attractive prospect. Australia’s higher interest rate, and economic strength driven by the commodities boom, both strongly appeal to international investors. For an economy based on a population of 23 million, to have such a high-ranking currency is impressive.
But the rise of the Australian dollar has severely affected Australian importers and exporters. It can be a particular challenge for Australia’s 1.2 million small-to-medium enterprises.
Over the past 24 months the Australian and US dollars have danced around parity, AUD/USD hitting lows of 0.8070 to highs of 1.1079. A company selling AUD100,000 and buying USD would have seen a USD30,000 difference in costs in the 12 months from mid-2010 and to mid-2011. With AUD/USD having recently hovered above parity, many sellers of AUD have been content to ride the wave and buy USD cheaply.
But how long will the Australian dollar’s strength last? Companies often become complacent when the “good times roll”, swapping common sense for optimism, and believing a strengthening AUD will continue forever. Likewise, buyers of AUD often refuse to believe that a currency move against them will continue, and that short-term pain may quickly change to their advantage. Optimism again replaces objectivity: the market rises, and a minor issue balloons into something far worse, increasing costs, cutting profit margins and hitting the bottom line.
Experience shows that many companies only take an interest in FX rates when it’s already too late, and the market takes a turn for the worse. Smarter companies are those that plan ahead, who take FX risk into consideration, and who realise that even smaller, unlisted companies need to hedge FX risk and protect themselves.
So how can a company better protect itself from FX volatility? By understanding what the risk is, following a few simple rules, investigating the FX hedging tools available, and choosing a hedging strategy which best matches their needs.
The smart approach to FX hedging is simple. First, you need to understand the link between a company’s costs and FX risk. Most businesses, whether product or service orientated, fall into two cost categories. Some costs are relatively static over a certain period, whether a financial year, or the lifecycle of a project. But other costs are more fluid, and move around on a weekly or even daily basis.
To establish a hedging strategy, a business needs to recognise whether its costs are more fixed or more fluid. Those with static costs will have greater opportunity to lock in FX rates in advance.
For example: a plastic bags manufacturer has a year-long contract to supply a supermarket with a set amount of units each month. Therefore the manufacturing company knows in advance how much Polyethylene to buy each month. If it imports polyethylene in USD and agrees to a 12-month contract with its supplier, the FX risk will be the underlying changes in AUD/USD.
During the 12-month period, FX rates could move the actual cost price far from the budgeted cost price. So the manufacturer might consider locking into a string of 12 single FX deals each month, matching the payment schedule. This mitigates downside risk, locking prices down for the 12-month period. This means that the manufacturer wouldn’t benefit from favourable currency movements, but the peace of mind gained by avoiding unfavourable ones is arguably more worthwhile. Likewise if new contracts are won, additional cover can be bought and hedging topped up.
Businesses with flexible costs are better suited to a hedging strategy which is equally flexible. For example, would a tour operator, with tight profit margins and a constantly evolving cost line, benefit from locking in forecasted costs twelve months in advance? The answer is doubtful. A smart business would instead consider a dynamic hedging strategy, using a number of products to give a blended or average rate over the full year period. A dynamic hedging strategy requires consistent vigilance of currency market movements on an ongoing basis.
Whether facing fixed or fluid costs, smart businesses will recognise the challenges posed by FX risk and deploy an appropriate strategy to offset the risks judged as most threatening. It’s rare for an FX hedging strategy to give absolute protection. Crystal balls and silver bullets sadly don’t exist! But a business which recognises both the benefits and limitations of FX hedging will be the most effective at forming strategies.
Those organisations which recognise the threat posed by FX risk, and form a considered approach on countering these risks, regardless of complexity, will be the smart ones.
Key considerations in building an FX hedging strategy
- Identify what FX risk means for your business: its impacts and sensitivity.
- Identify ways of removing FX risk from the start.
- Set out clear risk management objectives.
- Don’t speculate.
- Seek professional assistance from the marketplace.
- Regularly review the performance of any hedging against your expectations: look back to where you were when you instigated the strategies, what happened in the market and the results of your strategy.
- Diversify your risk: blend a number of different strategies for example, a mix of spot and forward contracts or spot, forward and options.
