Hedging is just gambling isn’t it?
You’d be surprised by how many times I have been asked the question ‘hedging is just gambling’ isn’t it? The answer is always the same – ‘no’. Indeed hedging is the very antithesis of gambling. My head of desk puts it best when speaking to clients; ‘If you are not hedging then you may as well take your gross margin and put it on the 3 o’clock at Newmarket’.
But why should I care about managing currency risk in the first place?
While the foreign exchange markets have always been open to fluctuations, trading conditions and patterns have changed over the past few years – ever since the financial meltdown in 2008. The trends are becoming short term in nature and fluctuations are high with frequent directional changes. So much so that a 1% move in currency exchange rates could impact on your business – as much as 10-20% down on gross margin levels. Financial decision makers can no longer afford to be laissez faire about managing currency exposure. Of course the question of whether to hedge your exposure is always a big one. You may wonder whether it will be suitable for your business, when to hedge and how? Perhaps most importantly, you would want to ask yourself- how should my hedging strategy look?
How do I know whether I need to hedge?
If you are the finance director, it’s understandable that you may be reticent or even fearful of committing to buy something before you are absolutely sure that your business will need it. However if contracts are already agreed, or you have a sales pipeline that you believe in, then surely you can feel comfortable enough to hedge based on them? Some FDs hedge their currency based on specific contracts with a customer, while others hedge for the full 12 months based on sales/buyer projections; some hedge the repatriation of profits from overseas offices and others hedge the costs of running overseas offices. Regardless of the motivation, there is never an FD that is 100% certain that they will be able to deliver on the hedge they put in place, but in business who is ever 100% certain of anything?
One should weigh up the likelihood of a specific outcome and take a decision. There are then other things one can do to minimise the risk of their commitment. For example, only hedge 75% of your expected exposure, so that if your sales director reports a shortfall, you are not over committed. Or hedge your contract for delivery three months after the expected completion date of the project – you can take delivery early but if there is a delay, you have some time on your side.
How and when should I hedge?
Once a new client is comfortable with the issues outlined above, and have decided that hedging does fit their business model, the question of “how” and “when” are to be considered. This is where the most ambiguity lies, as there are never two hedging strategies that are the same. There is no basic model to follow and each business must consider the products, time frames and goals that apply to them.
Simple hedging strategy
Take the example of one business I work with – say Business A, an importer of tyres from China. The company pay its supplier in US dollars and budgets goods at a GBP/USD rate of 1.50. The sales director informs the FD that a new contract has been agreed with a customer that will need finance to buy $1m to pay their Chinese supplier in five months’ time. The business is very risk averse and the ability to guarantee the gross margin of this contract is all important.
In this instance, a very simple hedging strategy applies. Let’s say that on the day the contract is agreed with the customer the 8 month forward buying rate is 1.5350. It would be wise for the FD to hedge a significant proportion of the $1m at 1.5350 on a standard forward contract with eight months value. This will lock in a rate for this contract well above the budget level thus guaranteeing the gross margins on the contract. The FD doesn’t have to be concerned with where the live FX rate is on the day that payment is to be made, or how much higher or lower it gets in the meantime. His goal was to protect his margin and that’s what he has done. No gamble: protection.
Flexible hedging Strategy
To contrast, another business (Business B) I work with also import tyres from China but sell them to their customers from a catalogue that offers fixed prices over 12 months. Therefore, they are committed to a 12 month budget level, also 1.50. However, they are larger than business A and as such are in competition with some of the major tyre importers, who regularly offer discounts or special offers that make their goods cheaper than business B’s. Therefore, business B looks for any opportunity it can, to gain a competitive edge – and FX presents one.
In this case the FD might adopt a more flexible hedging strategy that offers the chance to capitalise on upside FX movements throughout the year. For example, they might hedge 40% of their annual requirement at the 1.5350 level on a 12 month forward. They may then take some options contracts that protect a slightly lower rate, but allow them to capitalise if the markets move higher on the day the options expire. Most likely, they will also leave a proportion of their requirement unhedged and hope to take advantage of any spikes in the spot market that will make their goods cheaper and allow them to discount and stay competitive.
Selecting a suitable strategy
In comparison to the basic strategy, the flexible strategy has portions of the FX requirement unhedged and therefore carries more of a risk. If the market rate falls throughout the year, the unhedged requirement will come in below budget level, impacting margins of the business. This is a risk that the FD should be willing to take, as he has to retain the possibility of discounting of special offers and a better FX rate provides this.
What I am hoping to show with the above examples is that every business has different reasons to hedge, and therefore different methods of hedging. The only thing that remains constant is the protection that hedging offers. Doing nothing is the ultimate gamble.
Torrie Callander is a corporate dealer at Global Reach Partners