Why do I need to hedge my FX exposure?

The rate could fluctuate in my favour.

Hedging foreign exchange currency exposure is a discussion that often takes place at board meetings between Sales Directors and CFO’s when a firm’s policies are being put in place.

There is no clear or straightforward answer to this issue, but it always pays for your business to take external advice to be entirely up to date and informed as to what the options are.

An advisor from a payments firm, such as CurrencyTransfer.com, will never advise a client not to hedge his exposure but it is also unlikely that he will advise you to hedge 100% either. An experienced and knowledgeable advisor will be able to explain and offer several foreign exchange hedging strategies that he believes suit your business from a risk and comprehension perspective. Building a relationship with a payments provider will offer a degree of comfort.

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considering a hedging strategy
The first step to be taken when considering a hedging strategy is: should I hedge at all? The answer to that is categorically yes. Your business might be to produce competitively priced goods to sell into your chosen market or to provide raw materials that allow others to operate their supply chain.

By choosing not to hedge you are speculating on the foreign exchange market. Your external auditors or accountants will strongly advise you to put in place a hedging strategy.

Whether you are a buyer of currency to settle invoices you receive or a seller of currency as you have agreed to invoice your customers in foreign currency you first need to understand how much you need to buy over a given period, say one year, and then break it down into individual tranches.

For example, let’s say that your projected total purchases in euros in a year total one million. That is equivalent to €83,333 per month. But it is doubtful that every month is the same due to seasonal factors. Your accounting team will have data as to the percentages of the total purchased monthly.

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The simplest method of hedging currency exposure would be to purchase the entire amount for immediate delivery then place the funds in a series of deposits until the invoices become due. That, however, is a poor use of cash flow since the funds would be idle.

one of the strongest and most cost-effective tools
A far more efficient yet simple method would be to buy the currency for future delivery. The funds will only need to be paid for when they are due to be paid but you will need to place a deposit of 5% of the amount you are buying with the currency provider to cover the risk involved.

This is known as a forward contract. It is one of the strongest and most cost-effective tools available through companies like CurrencyTransfer.com when hedging foreign exchange exposure.

Prior to considering hedging foreign exchange transaction exposure it may be worth contemplating the risk tolerance that you have as a business. It may be that you could be prepared to risk say 10% or even 20% of the invoice amount should the hedge prove to be unsuccessful and the market does in fact move in your favour over the period.

In such an event event you may purchase, say, 80% of your currency requirement (using a forward contract) and the balance at the time it is needed. In that way, if the market has moved in your favour, you can benefit to the value of 20% of the invoice amount if it has moved against you, you have risked only a relatively small part of the total.

future delivery differs from immediate delivery
The price of a currency for future delivery differs from the price for immediate delivery by the interest rate differential between the two currencies. This price differential takes away the ability to make a “risk free profit” when trading currencies.

It may be that your firm has been successful in buying currency as and when it is needed but that is a matter of luck and it will not pay in the long term. Hedging foreign exchange exposure is not a ploy by any FX provider to “lock you in” to dealing with him. A trusted adviser will always tend towards a conservative approach and this will certainly be appreciated by your accountants.

About Alan Hill

Alan has been involved in the FX market for more than 25 years and brings a wealth of experience to his content. His knowledge has been gained while trading through some of the most volatile periods of recent history. His commentary relies on an understanding of past events and how they will affect future market performance.”