Hedging currency risks can be simple and cheap

Hedging currency risks can be simple and cheap !

Managing currency risks does not mean that you should try to predict future exchange rates; it is precisely the opposite. A formalized risk management strategy is even more necessary since we do not know how currencies will fluctuate, or by how much ! The back testing of analysts’ or markets’ forecasts show this clearly (see Perspectives On… N°3)

Why some companies do not hedge their risks when they should

The volatility of exchange rates impacts negatively international business because it generates instability and lack of predictability of revenues, costs and therefore profit margins. Despite that, a lot of companies do not or only partially hedge their currency risks. There are several reasons: some companies think that foreign exchange risk management would be too complex, expensive or require too much time. Others don’t know enough about the instruments and hedging techniques, that gains and losses eventually offset each other over time making hedging useless, or even that hedging is a speculative action !

It is incorrect to say that hedging is expensive or complex: hedging can be simple if a customized policy is established beforehand, using simple products. Moreover, it is not necessary to know the exact payment amounts or collection dates in advance since appropriate management can easily solve this. Finally, foreign currency fluctuations may (but not necessarily) compensate each other over years, but would the company’s financial structure be able to accommodate a very strong, sudden adverse change?

The different types of currency risks one need to be aware of when setting up a risk management policy

• Operational risk related to current or future transactions, whose commercial terms can be multiple: tenders, framework contracts or firm orders, price indexations, payment methods and delays, etc.

• Financial risk, linked to dividends and intercompany loans or external debts in currencies;

• Translation risk related to the conversion of statutory P&L and balance sheets into consolidated financial statements;

• Economic risk relating to the elasticity of sales to foreign currency fluctuations.

It is possible to mitigate currency risks, applying appropriate hedging methods to :

• Minimize the effects of exchange rates fluctuations on earnings;

• Increase predictability of future cash flows;

• Facilitate the pricing of export and import;

• Temporarily protect competitiveness in a difficult environment and give time for managers to set up new solutions (price increase, reorganization or relocation of production or supplies, for example).

In addition, one must consider the specificities of the countries and currencies involved, for example: more or less volatile, transferable or convertible currencies, high or low interest rates impacting the forward rates (“swap points”), hedging instruments proposed by the banks.

The inception of a formal currency risk management strategy is essential to achieve this success. Several steps are generally recommended.

First step: identify and quantify the currency risks to determine their impact and stake.

Second step: formalize a policy, i.e. define the hedging objectives, the practical modalities and the reporting and accounting needs (performance monitoring, regulatory or IFRS), as well as the market surveillance. These arrangements should consider the following :

• When the company should start hedging its risks and on which maturity: an important question since risk occurs before invoices are issued or received ! It is therefore important to accurately monitor the emergence of risks.

• Tools and instruments that may be used and under what circumstances;

• Responsibilities: decision, implementation, controls;

• How will the results of hedging transactions be measured ?

• How the market will be monitored in order to adapt the hedging decisions to favorable or adverse significant fluctuations.

Third step: implement hedging according to the predefined policy at optimized market conditions so that the direct or indirect costs do not jeopardize the effectiveness of hedging.

Fourth step: produce precise controlling reports to evaluate the effectiveness of this policy in offsetting risks on cash and on P&L. On this basis, with simple principles and common sense, most companies could improve their currency risk management practices.