The global economy becomes more intertwined each day and more companies are finding themselves faced with the difficult decision of how and when to hedge foreign exchange (FX) exposure.
Global exposure and currency risk, once limited to the Fortune 500, have found their way into middle market companies and even into mom-and-pop enterprises that are now balancing suppliers in Asia, middlemen in South America, or clients in Europe, says Garry Duncan, CAIA, managing director, PNC Capital Markets, Foreign Exchange.
“FX risk, if not properly monitored and managed, can negatively impact margins and potentially erode competitive advantages, so finding the right hedging solution is an imperative,” says Duncan.
Smart Business spoke with Duncan about Rolling FX hedges and how to approach hedging decisions.
What is prompting companies to employ Rolling FX hedge strategies?
Economic uncertainty continues to dominate the headlines and global foreign exchange markets remain volatile, making any hedging decision even more challenging. For example, the fiscal crisis brewing in Greece has prompted a nearly 10 percent decline in the euro since mid-December 2009. While this might elicit cheers from importers enjoying a decline in the cost of goods purchased from European suppliers, it would no doubt prompt tears from exporters lamenting the decline in the U.S. dollar value of their European sales efforts.
This relatively simple hedging program helps to take the guesswork out of how and when to hedge and smooth volatility while retaining the flexibility to respond to changes in the business environment.
How do Rolling FX hedges work?
Rolling FX hedges are similar in concept to dollar cost averaging. Both are based upon taking multiple observations over the course of the investment, or hedging period. Rolling FX hedges produce an average, or blended, FX rate that will reflect activity over a defined period rather than a one-and-done approach that locks in a lone FX observation for a quarter or an entire year. This blended rate, derived over time, will also be consistent with the underlying exposure being hedged. In other words, if all your revenue or costs can be boiled down to one day, then perhaps the one-and-done approach works. However, the more traditional course of business suggests that these types of exposures are generated over time, which would be consistent with a blended FX rate constructed over the hedging period.
How can a company start implementing a Rolling FX hedge program?
The first step toward implementing a Rolling FX hedge program is to identify FX exposures and define cash flow requirements in the underlying business. Once these items are known, a company will then be in a position to establish initial FX forwards with maturities that are consistent with both defined cash flow needs and appetite for risk. For example, initial forward trades for a U.S. importer hedging exposure of 1 million euros per month might look like this:
- First month, buy 1 million euros.
- Second month, buy 750,000 euros.
- Third month, buy 500,000 euros.
- Fourth month, buy 250,000 euros.
Once the initial forward FX contracts are in place, companies incrementally adjust existing hedges at defined intervals, essentially building on and extending an FX maturity ladder that will match cash flow exposures.
Note that Rolling FX hedges ensure that the near month is 100 percent hedged, removing concerns about immediate cash flow needs, while future exposures are hedged in layers, allowing the company to retain the flexibility to adjust to a changing business environment.
This is the key to achieving a blended rate while reducing the impact of market volatility and retaining flexibility.
What are the advantages of Rolling FX hedges?
Let’s return to our example of a U.S. importer hedging 1 million euros per month or 12 million euros over the year. Instead of implementing the Rolling FX hedge program detailed above, the importer decided on Jan. 2, 2009, to deploy the one-and-done approach and purchased 12 million euros at a rate of $1.41. On April 1, 2009, the importer realized that sales were off more than expected and it needed to pare back orders, leaving it overhedged by 2 million euros. Instead of just adjusting future purchases of euros to reflect the current business environment, the importer had to reduce its outstanding hedge by selling 2 million euros at the then-prevailing rate of $1.31, translating to a $200,000 loss.
Who can benefit from Rolling FX hedges?
Importers and exporters are not the only types of companies that can benefit from Rolling FX hedges. Companies that receive predictable dividend or royalty payments, organizations that fund international operations through scheduled capital payments and global corporations with intracompany loans or payables can also benefit from using Rolling FX hedges.
Rolling FX hedges provide 100 percent hedging in the near term and better management of foreign exchange exposure over the long term. Using this flexible, programmatic approach, companies can adjust hedges at more frequent intervals and manage changes in their business situation more effectively.
This article was prepared for general information purposes only and is not intended as legal, tax, accounting or financial advice, or recommendations to buy or sell currencies or securities or to engage in any specific transitions, and does not purport to be comprehensive. Under no circumstances should any information contained herein be used or considered as an offer or a solicitation of an offer to participate in any particular transaction or strategy. Any reliance upon this information is solely and exclusively at your own risk. Please consult your own counsel, accountant, or other adviser regarding your specific situation. Any views expressed herein are subject to change without notice due to market conditions and other factors.
©2010 The PNC Financial Services Group. All rights reserved.
Garry Duncan, CAIA, is managing director, PNC Capital Markets, Foreign Exchange. Reach him at (215) 585-6334 or email@example.com.