Trading internationally presents any business with some very exciting opportunities but also exposes them to some very dangerous risks. Perhaps the single biggest risk in transacting globally is the one posed by fluctuations and changes in foreign exchange (forex) rates; indeed, timing the FX market to try and get the best foreign exchange rate is not an easy feat at all.
In this post we will take a closer look at what these risks are and some steps that any business can take in order to mitigate them. We will examine how to hedge foreign currency, the benefits of currency forward, and whether forex currency hedging is really a viable protective strategy, or just an additional danger.
Why Timing The FX Market Is Important
Let’s start with the very basics. Imagine you run a US based company that manufactures coffee machines. You buy some of your parts from China and sell to clients in the EU market. In order to run your business, you therefore need to pay for supplies from China in Yuan (CNY) and you will need to accept payment in Euro’s (€). As such, your business is exposed to the whims of the forex markets. For example, if the dollar drops against the Yuan then the costs of production rise and the coffee machines become more expensive to produce. On the other hand, if the Yuan drops against the dollar then the parts become even cheaper for you.
Many businesses do not adopt any forex strategy and simply accept the ups and downs of the market as they come. Indeed, in times of global economic stability this non-strategy can work out pretty well as any losses in one trade are often recovered in the next.
But in terms of global uncertainty like we have been seeing for the past few years now, the fluctuations in the forex markets become more problematic. As such more and more businesses are looking into hedging strategies.
“Hedging a bet” is a gamling term which means trying to cover both outcomes. For example if you place a bet with one book maker that the Nicks will win the World Series but then bet with another maker that they won’t, you have hedged the bet. It is not seeking a win/win outcome, but simply seeking to curtail losses.
Currency hedging is slightly different in that it works by traders trying to “lock in” a certain exchange rate using various methods.
● Currency Forward
One example of currency hedging for business is when the business buys a certain volume of a foreign currency when the rate is favourable, even when it does not need the currency. Instead, when they do need it in the future (i.e. when the time comes to pay the Chinese invoice) they have the money ready and do not need to go to the Forex market which may have turned for the worse.
A variation on currency forwarding is Spot or Forward Contracts. This is when a business makes an agreement with a broker to buy a certain amount of a given currency, over an agreed period in the near future (usually 12 months max) at an agreed, fixed exchange rate. This means that the business does not need to buy all of the currency at once so this option is very useful for businesses that run a tight cash flow. Once again the advantage is that it “locks in” the exchange rate providing the business with certainty and protecting it against adverse drops in the forex market.
● Multi Currency Accounts
Another option a business can look into is opening a foregn currency account or a multi currency account. This simply means that they own an account where the balance is held in a foreign currency – they can then use this account to make or receive payments in that particular currency without having to use any form of forex.
If a business routinely transacts in one particular currency, then this can be both a cost effective and convenient way to do business.
To Hedge Or Not To Hedge?
Of course, there are potential downsides to hedging. Forex markets do move both ways and whilst sometimes the changes can hurt a business, other times they can be very beneficial. For example, let’s say our fictional company enters into Forward Contact to buy Yuan but the Yuan then declines against the Dollar, they will effectively be paying over the rate for the Yuan and not hedging would have produced the better outcome.
For this reason, many businesses prefer not to use any form of Hedging and prefer to simply try their luck. However, a recent and prominent example of the power of hedging was Brexit. When the result was announced, the Pound declined and as such, a lot of UK companies suddenly found themselves paying a lot more money to get their hands on Euros and Dollars. The businesses that had hedged (either by opening foreign currency accounts or forwarding) were protected against the drop but ones that had failed to hedge, were left very vulnerable very suddenly.
Finding The Best (Foreign) Exchange Rate
When it comes to timing the FX market, knowledge is power. Wherever or nor your business chooses to hedge, what is important is to always shop for today’s best bank transfer exchange rates. Knowing the current market rate will help any business to better predict future trends and better decide on its medium to long term forex strategy (or non strategy).
How to Hedge Foreign Currency When Its Income
So far in this post we have focused on the pros and cons of hedging currency for the purposes of business expenditure. This is because typically, when a business receives payment in a foreign currency they convert it into their native currency and get it banked, so that they can use it for domestic operations or set it aside for tax purposes.
Sometimes though a business may wish to hedge its income and leave it in a foreign currency. Instances of when this may be beneficial include when a business knows it will need to make a purchase or payment in that currency in the future. Using our coffee machine business example, let’s say they receive €10,000 from a German client – whilst they could convert it to USD and bank it, they decide to leave it in Euros as they know that they will be paying an Italian contractor in the near future so can save costs by keeping the Euros aside for that purpose.
Another instance of when a business may wish to hedge its income, is when they expect their native currency to decline in the near future. The current forex rate is €10,000 = $11,236.71 but in the near future the dollar may decline meaning that those Euros would be worth more. This is a very risky strategy as it can mean businesses losing out, and can also leave them with inflated tax liabilities. It also effectively means betting against one’s own currency which does not sit well with some business owners.
Final Thoughts on Forex Hedging
As you can see, timing the FX market is not simple. Therefore many businesses engage in currency hedging or currency forward in order to try and secure the best exchange rate for an international money transfer transfer.
We hope you found this helpful and hope you know a little more about how to hedge foreign currency. Happy trading.
The ultimate verdict on why to hedge is cases like Brexit, massive drops against your favour can risk your business. A non-UK business that has had most of its treasury in Sterling because it gets paid in Sterling would have lost easily 5%-10% of its reserves over a very short period of time.