In today’s global economy, American
companies are afforded tremendous
opportunities to diversify business risks and capture additional market share.
However, there are corresponding risks to
the rewards that are associated with conducting business internationally.
Highly volatile, any given currency fluctuates 1 percent during a 24-hour period,
points out Gary Loe, vice president at
Comerica Bank. This volatility translates
into the need to manage the risk of rising or
falling foreign exchange rates.
“Identify your exposure and establish a
floor or worst-rate scenario,” advises Loe.
“Protect that rate by using one of your foreign exchange hedging vehicles.”
Smart Business spoke with Loe about
the basic principles of foreign currency
hedging, what the current environment
looks like and how to best strike a balance
between risk and return.
How does foreign currency hedging work?
A foreign currency exposure is typically
created when a company imports, exports
or establishes an offshore physical presence. Due to potential valuation change
from one currency to another, the result is
currency risk. This risk will require active
management or risk transfer. Whichever
occurs, a currency hedge program should
be investigated. Different companies will
have a different hedging profile. Hedging is
the tool to address currency risk.
What are the different types of foreign currency hedging vehicles?
There are three basic vehicles, although
there are variations upon these three.
The first type is a spot transaction, which
is the immediate buying or selling of one
currency for another. Using the market
price today, settlement usually takes place
within two business days. A company that
only transacts using spot trades is typically
accepting the most risk.
The second vehicle is a forward contract.
The price is locked in immediately, but settles on a date in the future. Monies do not
change hand until that stipulated future date. Theoretically, the forward price can
be the same as the spot price; however, the
forward price, based on interest rate differentials, is usually either higher (premium)
or lower (discount) than the spot price.
Finally, there are option contracts that
provide the company the right, but not the
obligation, to purchase or sell a specific
amount of foreign currency for a specific
date in the future. For this right, the purchaser of the option pays a premium which
is payable immediately. This cost is determined by many factors including the
option strike price, current spot price, forward adjustment (interest rates), market
volatility and forward date.
When creating a hedging plan, what strategies should be considered?
First, it is important to note that there is no
one best way to create a hedging plan. Each
company may determine to use different
tools that apply to its individual situation.
However, one consideration that should be
taken into account is how much exposure
you have. Are you conducting business in
U.S. dollar terms or foreign currency terms?
Even if conducting in U.S. dollar terms, your
company can still be exposed to exchange
rate movements if your foreign party is or feels forced to change those terms due to
exchange rate movement. Developing a
budget or other financial analysis can help
identify foreign exchange exposure.
Typically, a company will establish a budget
or forecast, then choose the vehicles to use
and subsequently validate them against the
company’s appetite for risk.
What does the current environment for foreign currency hedging look like?
Most industrialized countries have freely
open markets in foreign exchange such as
the U.S. dollar, Euro, British pound, Japanese
yen and Canadian dollar among many others.
The foreign exchange market is the largest
market in the world with more than $1.5 trillion (U.S.) traded daily. This is bigger than all
the stock and bond markets in the world put
together. Therefore, the market is very liquid.
There are, however, countries where it is
very difficult to impossible to physically
deliver currency. China is one such place that
curbs its money flows. This is due to Chinese
central bank restrictions. Regulations in
some countries can change constantly so it
can be important to stay in touch with your
bank’s foreign currency adviser.
How can a business best strike a balance
between risk and return when hedging in foreign currencies?
Probably the term with more weight is risk.
Your company is probably not in the game of
foreign exchange speculating. It is most likely buying or producing a product for sale or
providing a service for sale. Therefore, it
should concentrate on what it does best.
Most companies would be better served
by eliminating as much foreign currency
risk as possible. However, some business
situations cannot completely eliminate
risk. In this situation you can try to set a
downside floor with the use of such vehicles as options. Setting a floor with an
option or leaving an order to buy or sell on
a stop-loss basis can also leave potential
upside returns on a hedging strategy.
GARY LOE is vice president at Comerica Bank. Reach him at
(800) 318-9062 or [email protected].