Hedging Currency Risk-A Review

This post has already been read 86 times!
0 Flares Twitter 0 Facebook 0 0 Flares ×

Hedging CurrencyJust ask any US exporter to the UK who agreed to accept the British Pound (GBP) as payment instead of the US dollar and they will tell you what a mistake that was. Indeed, since the announcement of Brexit, the GBP has plummeted close to 20%, and the relative US dollar and the decline is far from over (Some forecast the GBP at $1.05 later this year). That means the US exporter lost 20% of the value of the export invoices. A big hit to the bottom line.  Across the Atlantic, UK importers who were not able to negotiate payment in GBP took the hit as the US dollar became more 20% more expensive. Given that many companies have less than a 20% profit margin, the devaluation of the GBP relative to the US dollar could become fatal to some companies.

But for most multinational companies, currency risk is part of doing business. However, during the promotion of “going global” some domestic companies new to the export market may have learned about currency risk the hard way by not understanding how to hedge currency risk. Given the current political uncertainties and the potential effects on the currency markets, reviewing basic currency hedging is in order.

Currency (FX) risk is the danger that fluctuations in the home currency value relative to other currencies and how that can will affect profitability.The issue isn’t that currency risk is poorly understood—most exporters and importers know that unfavorable FX fluctuations can undermine their profits and cash flow. Even so, many of them don’t manage their FX risk in a way that helps them maintain their margins and their overseas growth.

There are numerous ways to hedge currency risk, but most exporters/importers normally use an “FX facility,” which they purchase from their bank. An FX facility resembles an operating line of credit and can support various types of financial instruments, or hedges. These are all designed to lock in the FX rate for an export sale, reducing a company’s vulnerability to adverse rate changes. But getting the most out of hedging relies on knowing exactly when to buy an FX facility and start hedging, and this is where exporters can get it wrong.

Many companies don’t clearly realize when their FX risk becomes a reality, and they often wait to hedge their FX exposure until they issue the invoice, even if they finalized both the contract and the sale price months earlier. Indeed, the currency risk starts when the price is booked.

Hedging Period

As currencies fluctuate every few seconds, how should currency be hedged? Some companies will hedge for the estimated time of receipt of delivery (when the LC is formally accepted) or some time comfortably beyond that date. For example, if it normally takes 90 days from booked order to formal receipt of the order by the client, the option period would be for over 90 days. However, as the cost of currency becomes higher the longer the option period (“time premium”),  some exporters and importers try to time their options period in such a way that will minimize the time premium cost. However, that strategy can be risky. On the other hand, there are some experts who feel it is a better strategy to hedge based on the estimated yearly currency risk exposure. For example, if a company has an estimated annual currency risk exposure of $100 million in offshore sales, the company would purchase 12-month options on that amount. Of course, each currency pair would need to be proportionally allocated.  But there is more to it than that.

For an options strategy to fully cover the hedged amount, the option must have a high “Delta.” What is Delta? Without diving too deeply, Delta is a measure of the probability that the option will be “in-the- money” by the end of the option period. Unfortunately, the higher the Delta, the higher the option premium.

For example, if you wanted to hedge your annual sales in USD to the UK and you accepted GBP payments, you would short  GBP/USD options and make money on the downward movement of the relative valuation, and the hedged position would cover your annual GBP FX risk exposure for the entire 12 months. On the reverse side, UK importers would go long on USD/GBP options and make profits when the USD moved up relative to the GBP.

Using an ETF for currency hedging

Exchange traded funds (ETFs) trade very much like equities and have excellent liquidity. Over the past few decades, ETFs have become the darlings with investors and money managers as they provide diversification as well as liquidity. There are ETFs specifically designed for currency hedging depending on the country pairs. As the USD/GBP is currently in the spotlight, one such ETF is FXB one of two major players in the British pound space, and it dwarfs the asset base of its only real competitor, the iPath GBP/USD Exchange Rate Fund (GBB). The fund employs the simple strategy of holding physical pounds on deposit.

Cost-benefit analysis

As with all other “free markets,” demand will reveal itself in price. When deciding to hedge, a decision is made as to the cost benefit of paying the option premiums. The good thing about option premiums, they represent the maximum loss if left to expiration. However, there may be occasions when the cost of hedging may outweigh the estimated potential losses. In which case, just a portion of the estimated sales can be hedged rather than the entire estimated sales.

Using currency options is one popular way to hedge fluctuations in currency pairs. However, options are a complex subject and usually require an expert to help properly use the options strategy. However, there is an easier and perhaps much less complicated way to hedge.

However, as a disclaimer, we at Metaops are not recommending this or any other investment strategy.

In summary, we may be entering a time when some tectonic political changes may directly impact global trade and pricing. As a result, multinational companies should pay close attention to their currency risk exposure and develop a strategy that best fits before establishing contract pricing.