With the volatility of foreign exchange rates increasing dramatically over the past months and inflation making the value of currencies much less predictable, many small and medium-sized businesses are finding it increasingly important to hedge their foreign exchange exposure.
In this article, we will look at the reasons why you should consider hedging your FX exposure and the strategies you can use.
Do you need to hedge your currency exposure?
The BIS reported global foreign exchange markets reached a stunning $7.5 trillion per day turnover amid a higher volatility environment. Not all of this is hedging since a lot of speculation is present in FX markets.
Strictly speaking, you are not required to hedge your foreign exchange exposure unless you are a regulated business or have strict risk controls set by your risk management function or board of directors. What’s more, many small and medium-sized businesses don’t have a dedicated treasury function, and foreign exchange exposure is something that is often ignored when business is stable.
So does it make sense to hedge at all? In times of stability, this is not a big question. But when markets become unstable, currency exposure can quickly eat into the profits you make from your business. This is why you should use the following criteria to decide whether or not to hedge your currency exposure:
Your risk appetite
As a small or medium-sized business, your appetite for risk is typically low. You don’t like to speculate, and unless you’re an expert in foreign exchange or financial matters, you probably want to be covered in case your foreign currency receivables go against you.
If you are subject to regulatory requirements to monitor financial risks, in most cases, you will need to hedge your FX exposure to some extent and disclose unhedged exposures to your risk management function and board of directors.
Share of foreign currency transactions
If your business has a high proportion of foreign currency transactions, you will probably want to consider hedging the risks, regardless of your risk appetite and regulatory requirements. The higher the proportion of foreign currency transactions, the higher the risk of currency fluctuations.
When to hedge your currency exposure
Hedging currency exposure is never a bad idea, but in the following cases, it is essential to consider hedging strategies.
Dealing in emerging market currencies
If your business trades in emerging market currencies from politically unstable countries, you usually have no choice but to hedge your currency exposure. The question is how to do it, so that you can hedge safely and don’t get caught in the middle.
Unless you are a multinational company with your own treasury function, it is important to use a provider that is regulated and supervised in your jurisdiction and offers attractive rates and sizes for both buying and selling foreign currency.
CurrencyTransfer offers access to a network of FCA-regulated firms through a user-friendly and transparent platform.
High currency volatility
In many cases, even developed market currencies can be highly volatile. During Liz Truss’s brief tenure as UK Chancellor, the British Pound fell by more than 20% in a matter of days, only to recover quickly after Jeremy Hunt repaired the budget. Such instances of extreme volatility are hard to predict, which is why it is still beneficial to hedge large exposures to developed market currencies.
Exposure to many different global currencies
The more different global currencies you deal in, the greater your risk and exposure. You may be used to the extra risk, but the greater the proportion of your receivables and payables in foreign currency, the greater your exposure to a currency shock.
A high proportion of export sales
If your business is import-export or export-oriented, for example, in the technology and industrial sectors, many of your receivables will be denominated in foreign currency. In this situation, it is important to develop a proper currency hedging strategy using forward hedging or more sophisticated currency options such as swaps.
How to hedge your currency exposure
In principle, there are three main ways in which companies can hedge their foreign exchange exposure.
Spot hedging means that you simply buy foreign currency to make a payment in foreign currency or sell the currency in anticipation of a payment you will receive from a customer. It is useful for any payment that is due immediately, or ‘on the spot’, as the currencies are exchanged immediately. With this type of transaction, you can eliminate the risk of currency fluctuations immediately.
Forward hedging is the simplest way to hedge foreign currency receivables. If you export goods to a foreign country on payment terms or have a large backlog of orders in that country denominated in a foreign currency, you can hedge your exposure by selling the currency you are expecting to receive in a forward contract. In this way, your cash flows are hedged at the time of payment by your counterparty in the other country, and you do not have to worry about interest rate fluctuations or to hold the currency in the meantime.
Swap hedging is a more sophisticated form of currency hedging, typically used by the treasury departments of larger companies or financial institutions. Instead of buying or selling actual foreign currency, you can enter into a swap agreement with a counterparty to exchange currencies at a specified future date.
The advantage of swap hedging is that there is no notional exchange when you enter into the swap, just an agreement. This means you don’t have to put up any money. At the end of the swap’s term or at agreed intervals, payments are exchanged only for the gain or loss resulting from the transaction.
As a result, your risk is hedged synthetically without touching the foreign currency at all. However, you must be able to rely on your counterparty to remain solvent and make a payment to you when it is due (or vice versa).
Looking for foreign exchange hedging for your business?
Currencytransfer gives you access to a range of FCA-regulated FX providers trading at competitive prices. Join our platform now and we will allocate you a relationship manager to help you establish the best strategy to hedge your foreign exchange risk.
Gustav Christopher is a writer specialising in finance, tech, and sustainability. Over 15 years, he worked in banking, trading and as a FinTech entrepreneur. In addition, he enjoys playing chess, running, and tennis.