FX Hedging is not Gambling

Many finance professionals in small corporations find dealing with foreign currencies quite challenging. Surprisingly, only 4% of UK SME exporters hedge their currency risks, while some businesses still consider FX forwards to be a form of gambling.

This raises a question: why do most major corporations adopt FX hedging strategies while smaller companies often see it as an unnecessary expense? This article delves into the most common mistake made by finance teams when it comes to hedging and presents a more structured and robust approach to understanding this complex practice.

The most popular (and often wrong) reason for buying FX forwards

Numerous finance professionals view the primary aim of "hedging" using FX forwards as securing a more favourable FX rate for future transactions. While this notion holds some truth, it fosters a decision-making framework that is too flexible, leading to unpredictable incentives and behaviour.

Traditional FX forwards are by far the most popular hedging instruments and enable businesses to fix today's exchange rates for a specified amount of currency to be exchanged in the future. By entering into FX forward contracts, parties agree on a predetermined exchange rate for future transactions, shielding themselves from fluctuations in exchange rates. This fixed rate mitigates uncertainty and provides stability for both parties involved in the contract, regardless of FX market movements.

When asked why they use FX forwards, all too often, people would say - they do it to get a better exchange rate, reduce their costs or boost their revenues. Unfortunately, setting the goal of achieving a superior FX rate through hedging requires individuals to forecast future exchange rate movements, a task fraught with difficulty. Even the most skilled FX traders in leading banks and hedge funds struggle to consistently predict currency fluctuations correctly, a feat made more challenging for small finance teams lacking the resources and information flow available to top traders. Attempting to outsmart the foreign exchange market by aiming for preferential rates when buying and selling currencies is akin to challenging a casino at its own game.

The unpredictable nature of FX rates contributes to the perception of hedging as a gamble, as individuals attempt to foresee future market conditions without a crystal ball. The fear of making incorrect decisions driven by current market rates is a significant concern for inexperienced finance managers and treasurers, who worry about the potential impact on their careers.

Experienced finance teams mitigate this unpredictability by aligning their hedging strategies with well-defined and communicated internal objectives and metrics and implementing processes to effectively manage uncontrollable factors like FX risk fluctuations.

Clear internal objectives

Although the primary objective of FX hedging may vary for each business, key common goals and strategies can provide stability to your hedging approach despite the fluctuating nature of exchange rates. The prevalent strategies include Balance Sheet Hedging and Cashflow Hedging.

Balance sheet hedging

A balance sheet hedging programme aims to safeguard profit margins against currency fluctuations reflected as FX Gains & Losses in accounting records. Typically, balance sheet items like foreign currency bank account balances, AP/AR, and other assets and liabilities in foreign currencies can lead to FX Gains & Losses for any accounting period. Often, foreign invoices are accrued at one exchange rate and settled later at a different rate, resulting in such FX Gains & Losses.

The significance of hedging is better understood when directly linked to underlying exposures. Assessing hedging performance accurately necessitates considering hedges together with underlying assets or liabilities in foreign currencies.

For many businesses, FX risk may be unidirectional. For instance, a company might solely buy or only sell in a foreign currency. In such scenarios, mitigating the impact of currency fluctuations on profit margins is achieved by hedging any contract or invoice denominated in a foreign currency promptly upon commitment. Nonetheless, understanding when FX risks arise is crucial. FX risks often emerge as soon as a contract is signed or even earlier, but accounting only captures a part of these risks - when invoices are recorded in the ledger.

In the above case, the exchange rates moved unfavourably from the time the sale invoice was entered until it was paid, and thus, the person who would have made the hedging decision looks like an unsung hero, even when the performance of the FX contract is viewed on its own. However, market exchange rates could also move in a favourable direction, in which case, the decision to hedge may seem like a wrong one - it would be better to wait and exchange currencies later.

If the decision to hedge or not to hedge is based on an individual’s views of where the exchange rates are going, the company risks ignoring the key fact. The company is exposed to currency risks in a specific direction, and it must hedge if it wishes to remove FX gains and losses from the income statement.

This is why it is important to view the hedges combined with the underlying risks to demonstrate their value: simply by fixing a predictable value of foreign invoices and thus protecting profit margins from unexpected currency swings.

In the above example the result FX Gain & Loss is nil - exactly the desired outcome.

Cashflow hedging

Now, imagine that the above-mentioned company decided to hedge such an invoice even earlier - when the sales contract is signed. This means the company would enter into a FX forward contract, locking in a guaranteed exchange rate of 1.2525 (1.2500 and a small cost that needs to be often paid to purchase a FX forward).

As a result, the company would lock in the value of £79,840.32 ($100,000/1.2525). More importantly, when the client pays $100,000 a month later, the cash flow can be exchanged at the guaranteed rate, and the company can collect the full £79,840.32.

However, in this case, the hedge existed even before the invoice appeared on the balance sheet. Until the invoice date, this hedge relates to a forecasted transaction. Such a hedge is called a cashflow hedge because it does not deal with risks to balance sheet items but those of future cashflows. Cashflow hedging can be used to remove the FX uncertainty from various future cashflows that are highly likely: forecasted payroll, purchases, and sales.

Companies usually use cashflow hedging to protect the value of these future cashflows from currency volatility by entering into a forward contract for parts of the expected currency exposure arising from such cashflows.

Rather than focusing on specific exchange rate levels, cashflow hedging usually dictates a certain percentage of exposure to be hedged for future periods. Hence it works on the same principle as balance sheet hedging — aiming to reduce the uncertainty around the value of future cashflows in foreign currencies when revalued in the home currency.

Clear risk tolerances

In both cases, rather than aiming to get the best FX rate both strategies have the reduction of uncertainty and risks as their primary goal. This goal must also be combined with a defined risk tolerance to make hedging decisions practical: there is no need to hedge risks if they are immaterial, but there has to be a loss level that the company does not want to breach. Such a risk limit is what can make the treasury or finance manager’s job easier - they should know what risk they can and can’t take. It can be as simple as a notional value of aggregate currency exposure: “We cannot have more than $XYZ of upcoming invoices or cashflows in foreign currencies unhedged”.

If you are struggling to decide on the right objective and risk tolerance, it may be useful to ask an experienced treasury consultant or a peer to help you with a review. They can also review actions that you can take to mitigate FX risks even before considering FX hedging. If however, you are finding yourself having to regularly adjust your prices and reduce discounts to offset currency fluctuations - it could be a sign that you need a better FX risk management framework.

The role of timely data

Out-of-date data is the number one enemy of effective hedging. As FX markets move constantly, it is usually true that it is better to have 80% accurate data about your currency exposure but make the hedging decisions as soon as your exposures reach a certain level. Modern automation systems can also help significantly streamline currency management. It is possible to combine speed with the flexibility of rule-based hedging that allows finance teams to make timely decisions when exchange rates are good or when risks are high. With a focus on devising a robust hedging strategy that leverages automation, you can combine the primary goal of reducing uncertainty with a robust framework of always getting FX rates that help you keep your profits and cashflows healthy.

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