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 firstname.lastname@example.org.