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Currency hedging costs and the value of protecting SMEs

The approach of small and medium-sized businesses towards FX risk management is very different from that of large public firms and foreign currency hedging costs are to blame.  We look at hedging of foreign currency Accounts Payables and Accounts Receivables and how to think about the value of hedging relative to its costs below.
 
A vast majority of multinational corporates hedge their balance sheet systematically. Not doing so simply means having regular FX losses as a separate item on their Income Statements – something that investors and creditors are quick to jump on and penalize for. There are few things that a corporate CFO would avoid discussing on an earnings call other than foreign currency losses. This has led to balance sheet hedging routines being hard-wired into the risk-management policies of so many multinational corporates over the last 2 decades.

Nevertheless, the pressure from external creditors and investors is less likely to act as a driving factor for most small or medium business owners. In fact, a mere 5% of SME exporters surveyed by the British Business Bank in 2020 used foreign currency risk-management solutions. Why do they make such a different decision?

The decision of whether to hedge is made by small business owners or senior managers based on how they perceive the value of hedging. Such perceived value, in turn, is derived from comparing the financial costs and any other burden on oft-limited resources in a company to the risks of “not hedging”. While the former is relatively clear to the decision-makers, the latter is uncertain and difficult to estimate. Human biases such as “anchoring” or “recency” often lead to underestimating risks. People expect FX rates to remain in a familiar range no matter what uncertainty looms for a currency on the horizon.  Even when the market sentiment swings from greed to fear, humans rarely adjust their future expectations quickly enough.

The key to the right hedging decision lies in understanding how much currency could move relative to one’s margins. One of the simplest ways is to look at FX moves further back in history in order to estimate potential future ranges, especially if one can study a similar period in the past. Bank of England publishes history for many currencies here.  For instance, over the last 20 years Pound Sterling moved against US dollar by more than 5% over any 3 month period almost 20% of the time – even if the history is not the best predictor of the future performance, it certainly a useful starting point in assessing potential future ranges.

Another useful method is to use the historical data in order to compare the foreign currency hedging costs to potential ranges and what it means for your chances of being better off by hedging your currency risks.  Imagine companies A and B – the former never hedges its foreign currency payments and receipts, and the latter does.  Assuming future FX rates are unpredictable (they are most of the time) the company A runs a 50/50 chance of making or losing money from its activities due to FX fluctuations. At the same time, company B has a 100% certainty of paying some costs for hedging in order to avoid any FX effects – gains or losses from its activities would be offset by losses or gains from hedging.

Let’s say Company B‘s financial service provider charges 0.50% for the currency hedges – how does this cost compare to potential FX moves? It turns out that GBP has fallen by more than 0.50% against US Dollar 42 percent of the time over the last 20 years. This means that if the history is a good predictor of the future, company B (the “hedger”) is likely to be better off in 42% of the time comparing to company A, which would lose more – in fact, with a 10% chance losing as much as 10 times the hedging cost! The flipside, of course, is that company A would make money (or lose less than 0.50% of costs that company B pays) 58 percent of the time. This is why the magnitude of the hedging costs matters – lower costs mean company B will more likely be better off. It is no wonder that small business owners are deciding against hedging currency risks if some of them are still charged 2% or more for their hedging by their bank providers!

What is an acceptable cost of hedging? The answer to the last question is actually is less obvious and depends on something that is unique for each business – its risk tolerance, or specifically how much the company could lose.  The consequences of losing money or making profits become asymmetric once they reach a certain size.  If you lose too much – you may be out of business and don’t get another chance to earn future profits.  Every time someone exposes their business to a risk of substantial losses, they are risking their chances of future profits and in fact, reduce the value of their company.  This is why investors are so demanding towards the CFOs of public companies when it comes to risk management, including currency risks.

Small businesses active in cross-border trade should hedge more. When it comes to Accounts Receivables, small businesses are often slowest to be paid on their invoices in the global trade supply chains. According to the British Business Bank, small suppliers have on average their invoices processed 35 days after being received, often late before the invoice has even been received.  International invoices are more likely to take longer to be processed and paid.  Doing nothing to mitigate currency risks arising from such exposures may lead to unnecessary risks for a company’s margins.  Yet, many small businesses have to rely on thin margins to exist in an increasingly competitive world, spending all their time and energy to grow their revenues.

The ongoing pandemic as many crises before has shown that devising a cost-effective hedging strategy may go a long way in protecting the future of small businesses. At HedgeFlows we believe that our ability to reduce currency hedging costs for small businesses is key to enabling the right decisions by hundreds and thousands of smaller companies around the world, who are essential to the future growth and prosperity of the global economy. If you would like to be updated on how to achieve that subscribe to our updates.