How does a business mitigate currency risk?

The term Hedging is what is often referred to when talking about covering currency risk. Very simply, it is a strategy to protect your margin or limit your losses.

There are multiple ways of looking at covering your currency exposure. Most businesses want to be focusing on running their business, and not worrying about what the currency markets are doing.

Hedging is a technique used to reduce currency exchange risk, but it is important to keep in mind that nearly every hedging practice will have its own downside. Hedging is not a perfect science, and does not guarantee success, nor guarantee that all currency exchange losses will be mitigated. Business owners should think of hedging in terms of pros and cons and how it can be of benefit to their business.

So, what are the different ways a business can trade currency to mitigate risk?

Spot Contracts

‘Spot’ or ‘intra-day’ trading is where you will purchase the currency at today’s rate. Trading at ‘spot’ is one of the most common tools in the foreign exchange market, but this does mean that as a business you have zero protection against market movements, and no certainty on costs. Spot currency trades require immediate settlement of the trade.

Forward Contracts

Very simply, this is the same as a fixed rate mortgage on a property. By forward buying or selling of currency, this enables the business to buy or sell a predetermined amount of currency over a period of time, this could be 1 week or 24 months.

This is an opportunity for a client to ‘lock-in’ an exchange rate today when the market is favourable, for a future date when the contract is deliverable and settled.

Forward contracts can be with zero upfront cost, or with a deposit, and only paid for when the contact matures.

Forward contracts are not right for everyone, and of course, depending on the needs of the business may or may not work.

The following examples show potential ways a business could put a risk management strategy in place, and the upside and downside of doing so.

Let’s look at this as a working example:

A business wins a deal for USD 750,000 into GBP and being paid in 9 months’ time. If market was USD 1.25 today, this would equate to GBP 600,000 return for the business. This in turn is recorded in the business’ sales ledger as USD 600,000.

Option 1 – Do nothing, and trade at spot.

You may increase your Sterling return, but you may also end up losing on the deal.

On the day the invoice needs to be paid, the prevailing rate was USD 1.20 but the market moved to USD 1.30, this would be a sterling return of GBP 576,923.07. A loss of GBP 23,076.93 on the agreed terms. This movement in the markets would then need to be disclosed as an FX loss on the P&L for the business.

Alternatively

On the day the invoice needs to be paid, the prevailing rate was USD 1.20 but the market moved to USD 1.30 market moved to USD 1.20, this would increase sterling return to GBP 625,000. A sterling gain of GBP 25,000. This movement in the markets would then need to be disclosed as an FX gain on the P&L for the business.

Spot is 100% risk to the business, no certainty on cost, margin, or profits

Option 2 Forward Contract – Cover 100% of the amount.

If the client locked the rate in at USD 1.25, this would guarantee a Sterling return of GBP 600,000 as per the original agreement. This secures the profit on the deal for the business. 100% certainty to the business enabling them to carry on focussing on the business rather than what the markets are doing. The flip side here is that the business has not been able to benefit should markets move in their favour.

Option 3 – Cover 50% of the amount.

USD 375,000 @ USD 1.25, a Sterling return of GBP 300,000. This enables the business to use the remaining amount either at spot or additional forwards as and when the market moves. 50% of the outstanding balance is at risk.

The risk here is that the market continues to go against them. If market moved to USD 1.30, they would only get GBP 288,461.53 on the remaining amount. A total sterling return of GBP 530,769.23. Therefore, they will have lost GBP 11,538.47 by not securing the whole value of the contract.

The flip side is the market may move to USD 1.20, meaning an increase of Sterling to GBP 312,500 on the remaining USD 375,000. This would mean the business would have increased profit on the deal by GBP 12,500.

This above example is all down to the risk appetite of the business.

What is the right solution for managing risk?

In short, there is no right or wrong way for a business to manage their foreign exchange risk, but it is always worth having discussions to chat through the different scenarios and looking at the risks, costs, and of course market trends and forecasts.

This is a guest blog from Halo Financial and therefore does not necessarily represent the views of the Institute of Directors.