What is Currency Hedging?
Currency hedging is an issue that faces all businesses who import, export or who provide services overseas and invoice in foreign currency. Hedging of currency exposure is usually defined as the advance sale or purchase of foreign currency cash flows in order to protect the value of future cash flows in base currency.
How do we ensure that the value of our invoice is the amount that arrives in our bank account?
In the negotiation of terms when agreeing a contract with a new customer or supplier the payment terms are one of the most important factors. The buyer will want to pay as late as he can while the seller wants his funds as quickly as possible. This is a cash flow issue for both parties.
Payment terms can be agreed in advance but if the seller has to enter a contract with his FX partner then he will need to provide an exact date and that is not always possible.
For example, if the payment terms agreed are ninety days from shipment, then it is easy to calculate the exact due date from the bill of lading. However, what if the terms are ninety days from date of vessels arrival. That date is clearly indeterminate although a fairly clear estimate can be given.
This means that the supplier will receive his funds immediately less the cost of discount. Since the bank is simply making a payment in advance that it would be making in, say, ninety days anyway they will usually offer a fine rate which is in all probability cheaper than the exporters overdraft facility.
However, if the L/C is denominated in the currency of the buyer or importer, then the exporter still has the issue of foreign exchange hedging. He can simply ask the bank to pay the foreign currency to his FX partner but he will receive the rate prevailing at that date which could be vastly different to that which prevailed on the date on which the price was agreed.
There are several alternatives for FX hedging that the exporter can take advantage of
Currency hedging strategies should be discussed with an FX partner as soon as a contract is agreed in order to ensure that there is no loss from FX movements. In fact, a strategy could even be agreed in advance in order that the exporters sales team have a clear basis on which to agree terms.
In the case of indeterminate payment dates which are particularly relevant to open account relationships, arrangements can be made to either buy an amount of currency periodically which can be split into smaller parcels and delivered upon request or a purchase made of a specific amount to cover an individual sale with the actual date of delivery left open (within certain constraints)
In the former case, an exporter who sells to several customers in a single country or currency bloc can calculate fairly exactly his currency receipts on a monthly basis and arrange a contract whereby he has to deliver an amount of currency on a monthly basis but that amount may be broken down into smaller parcels. In the latter case, the exporter has to deliver the currency within a certain period (say a week) with a predetermined final delivery date
Hedging forex can seem confusing even to the most experienced CFO’s and Finance Directors but once a programme is in place for hedging FX exposure, cash flow can be improved and the bottom line protected.
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.”