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Managing Currency Risk With Forward Forex

Currency fluctuations need not be an issue for exporters with simple research and exmanination of your business and market, these strategies can help you  effectively currency-proof your business.

Can a business truly be currency-proof? It can get pretty close, say our experts from HSBC Bank Australia: Andrew Skinner, head of trade and supply chain, and Ian Collins, head of sales for global banking and markets. The key to currency proofing is not about gambling on the foreign exchange market, but examining your own business and finding out its requirements. Here’s a basic guide to the different forex strategies available.

How can exporters prepare for currency risk?
Ian Collins: “If you are trading in US dollars make sure you set up a US dollar foreign currency account as well as an Australian dollar account. To an extent, this insulates you from having to be absolutely precise in your timing of US dollar receipts. If you have a good understanding of the cycle of your business, then you can design a hedging strategy. The critical aspect is to model your cash flow projections as accurately as you can. Once you do that, you can effectively take out the negative currency risk because you’re hedging back the Australian dollars from that account so you don’t have to keep changing each individual contract.”

Andrew Skinner: “If you only had an Australian dollar account with your bank and you receive US dollars, they’ll be automatically converted into Australian and you’ll get the rate on the day which may not be the best outcome; there’s a timing risk.”

What strategies would you recommend to treat currency risk?
IC: “It comes down to the client’s own risk appetite. For example, you could enter into a forward foreign exchange contract and exchange US dollars for Australian dollars 12 months in the future at, say 93.32. The spot rate is currently 97.5 cents and the difference is the forward points, derived mathematically by the interest rates between the US and Australia—the US interest rate is 3.1 percent, our interest rate is 7.72 percent, so one year forward, the difference in the forward rate compared to the spot rate in forward exchange will be approximately five percent. That’s simplified, but that’s how you look at it.

“You’re not trying to guess where the currency rate is going to be, it’s just the mathematical difference between borrowing in one currency and investing in another. That locks away all your currency risk, but it may not suit everybody.

“Given where the Australian is in terms of its long term cycle, we’re seeing more exporters buying ‘disaster insurance’ by buying currency options, specifically Australian dollar call options, that is, an Australian call / US put. If the current spot is 97.5, you may want to lock away in your forecasts a worst-case rate of 99 cents for one year. You would probably pay $19,500 for that, per million-dollar contract. What does that give you? It gives you cover in one year’s time at a rate of no worse than 99 cents, but if it’s lower than 99 cents then you just convert your US dollars that you receive in one year’s time at the rate.

“Buying an option gives you more flexibility. Most exporters would tend to do it monthly, say for the next calendar year. At the end of the month they might buy a 99-cent call: at $1 million per month, it’ll give $12 million worth of cover in 2009 at nothing worse than 99 cents. They put that into their cash flows and don’t have to worry about the currency because if it’s lower, they get whatever the lower rate is and they’ve protected the worst-case rate. Think about it as insurance against a currency risk. You pay a premium and you get a worst-case level of cover.

“Some exporters are more sophisticated. They’ll buy an option at 97 cents and sell another at 102, above parity. By having what we call a call spread strategy, protecting against the Australian dollar going higher, they’re saying ‘we don’t think it’s going to go massively higher but I don’t want to pay too much for my protection, so if I buy my 97 cent call and sell one at 102, that’s reducing the cost of my strategy’.

“Another strategy is you buy a call option but you pay a premium at maturity and only if the exchange rate is at a certain level. An example of that would be to buy a 98-cent call today and you pay a premium if, at maturity in one year’s time, the exchange rate is at or below 102. Then the premium you pay at maturity would not be the $21,000 we said today but maybe $30,000 and then only if the Australian dollar is above 102. But if the Australian dollar is above 102 you pay nothing. Alternatively you could just choose to pay a fixed premium at maturity in US dollars matching the timing of the receipt of your funds.”

How much education does an exporter need to execute these strategies?
IC: “Not much, because you start at a basic level; it’s like managing your own bank account. We’d assess how financially sophisticated we think the client is: for the less sophisticated, we’d show them more vanilla strategies; if they’re more sophisticated we’d show them more complicated strategies. As we get to know the customer more and they become more sophisticated in terms of financial instruments, we can show them other strategies. It comes down to making sure the client understands what they’re doing and don’t take risks they shouldn’t be taking.”

AS: “Traditionally we’d use a trade transaction profile or cash management questionnaire to understand where they are now and where they expect to be, so we’ve made them think through their likely currency requirement before involving the specialists from treasury.”

Do the exporter’s credit facilities affect the type of currency option they should take?
AS: “We have some ‘over the counter’ style customers who might process US dollar receivables under letters of credit from Vietnam, for example. We can actually discount those documents in US dollars so we effectively have a currency match.

“We can do debtor financing in foreign currency, so we have a range of credit facilities that can be in multi-currency if it’s appropriate. The availability of debtor financing in multi-currency is probably not well known: a lot of people would traditionally convert to Australian dollars and just finance in Australian dollars.
“You’ll typically find that traders, or people with skinny margins, would lock in forward cover to maintain their profit margins. It’s customers with larger gross profit margins who can afford to play around and carry a bit more risk.”

How can a currency strategy help maintain consistent margins?
IC: “The secret is making sure your actual contract negotiations with the buyer are locked away at the right US dollar price. The coal exporters are a classic example: they negotiate out for a year both on a volume and price basis in US dollars. They then do the currency hedging because they know what their volumes and sale price are going to be.”

AS: “It’s very much part of understanding your product and your comparative advantage in the market so you know what margin you can sell your product for, and repricing that if the market moves against you. It’s ensuring you keep track of fluctuations and repricing for your next sales contract to avoid losing your profit margin.

“It also depends on cost base which is why we look at both sides: a lot of our clients may not have all their costs in Australian dollars, for example. They may be selling into a US dollar market and they may have costs in US dollars, so we can refinance some of their imports in US dollars to match up and have a natural hedge and just take out cover for the unmatched portion.”

Do the strategies differ for currencies other than US dollars?
IC: “It doesn’t matter what currency your contract is in, you can still hedge that currency risk out by approaching a bank and trying to predict as accurately as you can the maturity date of your contract. Once you have a maturity date and a notional amount of your contract, that currency risk goes away to the extent that you’re accurate in your forecast from the beginning. The level of accuracy you need around that is reduced somewhat by having a foreign currency account they can pay into and take out of.

“You might enter into a contract with someone in Vietnam who wanted to buy your goods. It would be atypical, but that company may decide they want to pay in local currency. We can provide that sort of hedging in local currency. Some markets are non-deliverable forward markets, which means you net settle the contract rather than have a physical payment in the foreign currency or receipt in foreign currency at maturity of the hedging contract. The physical payment would be converted onshore subject to the country’s exchange controls.

“The main currency that exporters would deal in, however, is US dollars, unless you’re exporting to Europe, then it’s the euro and so forth. We recommend that exporters denominate their contracts in whatever the best currency is for them to get the widest margin. They can then hedge out that currency risk as mentioned previously. Theoretically, an exporter should be able to sell and get the best profit margin by selling in the most liquid currencies, but that’s not always the case. It really does rely on accuracy of forecasting as much as anything.”

Any recommendations for exporters new to the foreign exchange market?
IC: “If you have no idea where the currency is going to go, do a forward contract and try and match your cash flow. If you think the Australian dollar is going to fall in the next few months and you want to hedge out a year, buy a call option so if you’re wrong, you’re still protected, and if you’re right you get a better result. Don’t do nothing and think ‘when it goes down I’ll put things in place’—that’s a currency view we tend to discourage, because it might go up. Either take forward cover or buy an option.

“Every now and again we see someone who wants to punt the currency because they think they can outguess the market. We tell them ‘you’re in business to sell widgets, you’re not in business to punt the currency’. If you can outguess the market, then maybe you shouldn’t be selling widgets—you should be in treasury.”

* Figures used were accurate as at July 21 2008.

call: a right to buy a particular asset at a specific price within a specific time; e.g. for an AUD call option, the right to buy Australian dollars.

forward points: the difference in interest rates between two currencies in exchange rate points, added or subtracted from the spot rate to give the forward rate.

hedging: protection of an asset or liability against a fluctuation in the foreign exchange rate.
non-deliverable forward market: a cash-settled, short-term forward contract on a foreign currency, calculated by taking the difference between the agreed exchange rate and the spot rate at the time of settlement, for the agreed notional amount of funds.

put: a right to sell a particular asset at a specific price within a specific time.

spot rate: the price of an asset for immediate delivery, or in the case of foreign exchange, for delivery in two business days.

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Adeline Teoh

Adeline Teoh

Adeline Teoh is a journalist with more than a decade of publishing experience in the fields of business, education, travel, health, and project management. She has specialised in business since 2003.

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