Global economic conditions have never been more hazardous to businesses than in the past several years. Brexit, COVID, the 2021 Suez Canal obstruction, and the Russia-Ukraine war have all generated unprecedented volatility in international markets.
The threat of GBP/USD parity has now become very real as the US economy remains stable largely thanks to favourable interest rate differentials and rising demand for the ‘safe haven’ US Dollar.
Meanwhile, the GBP has continued to devalue as the ongoing cost-of-living crisis worsens. In addition, recent tax cuts announced by Chancellor Kwasi Kwarteng, have caused the value of the Pound to plummet further.
In an unprecedented move, the IMF issued a statement to Truss’s cabinet. It warned that even should these inequitable measures succeed, they will surely worsen economic disparity in the country.
The Bank of England subsequently intervened to remedy the situation, buying back billions of pounds of Government debt. It hopes that this will drive down interest rates which have soared since Kwarteng’s fiscal statements.
Similarly, the EU economy has been rocked by a series of devastating blows causing the value of the EUR to plummet, reaching parity with the USD in July 2022.
FX hedging can help achieve a degree of certainty in uncertain times. As market behaviours change in reaction to global events, all businesses should prioritise key strategic and transactional considerations.
What is FX hedging?
There are no set exchange rates on foreign currencies. The value of one might weaken or strengthen against another over a long period, or even hour to hour. This can prove costly to businesses that sell in one currency, but buy in another.
FX hedging allows businesses to offset the risk presented by price fluctuations by locking in exchange rates for a set period using market tools, sometimes called ‘derivatives.’ Businesses use these instruments to protect profits when faced with volatile currency movements.
Businesses choose how much of their FX exposure they wish to hedge. Partially hedging a percentage of their foreign currency flow can help insulate against some of the effects of adverse moves in currency markets. Completely hedging can remove any exposure to future fluctuations, at the risk of potentially lower profits.
4 reasons why SMEs need FX hedging strategies
Adequate financial planning can often make the difference between success and failure. SMEs can lose their slim profit margins if they fail to grasp the importance of FX strategy. Here are just a few reasons to adopt a hedging strategy today:
1. FX hedging helps protect against market volatility
Currency risk is a common challenge for SMEs, whatever their industry. Due to the uncertainty and turbulence in the current global political and economic environment, business owners must be aware how currency volatility could impact their operations.
A majority of SMEs deal heavily in foreign markets and imports. Currency value changes, therefore, have a significant bearing on business performance. Volatility has a considerable impact on those businesses where costs and revenues are not denominated in the same currency, as is common in the industrial sector.
2. FX hedging aids stakeholder management
A 2019 analysis of the long-term sustainability of small and medium-sized businesses revealed that the capacity of SMEs to generate consistent revenue over time and overcome adversity depends primarily on the support of vital stakeholders.
The relevance of stakeholders – particularly concerning the funding and continued operation of startups in 2022 – has undoubtedly increased due to the current economic crises.
A solid FX hedging policy can demonstrate good governance and inspire confidence in investors as well as stakeholders such as clients, suppliers and banks.
3. Reduce the cost and time spent on FX risk management
Most SMEs rely on small groups of key staff for management and leadership. The cost of retaining a financial controller to analyse and manage FX exposure is often beyond the means of most.
Creating a data-driven FX hedging strategy can help ensure transparency and predictability in all FX-related decisions. Equally important, a robust decision-making process can help reduce the time and costs involved in planning and implementing FX strategies by introducing a degree of automation.
Predictability and consistency are crucial to the running of most businesses. FX hedging lends security and certainty to SMEs.
4. FX hedging provides time to pivot
Margin protection is essential when businesses conduct trade in different currencies. Foreign currencies often move more than tight profit margins can afford. FX hedging helps SMEs reduce currency risk exposure and adequately protect their margins.
Many SMEs hedge anticipated transactions to give themselves time to pivot in response to developing market conditions. The further in advance an SME hedges, the longer it has to plan before it experiences the effects of any change in currency rates.
For example, a company that hedges 12 months in advance each month means that the rate experienced in the market today will not impact earnings for 12 months. Should the market experience a period of volatility, they have 12 months to align added expenses with revenue.
Examples of successful FX hedging strategy
Companies are more aware of the need to prepare for an increasingly broad array of risks. Those who have seen the greatest success are, by no coincidence, those that have prepared for every eventuality. Here are two examples of how global enterprises have successfully deployed hedging strategies and benefited from the results.
Based in Sweden, Newgen Distribution is the leading distributor of Fitbit and associated brands in Europe. As of 2020, Newgen Distribution reported an annual turnover of €40 million as it broadened its product range to include robotics, drones and other technologies.
Most of their import purchases are made in EUR and USD, and the bulk of sales revenue is received in SEK. Consequently, Newgen Distribution is exposed to significant FX risk. Financial officers within the company recommended using a comprehensive FX hedging strategy to shield its bottom line from currency volatility. This policy later paid dividends when the COVID pandemic caused the SEK to plummet in value relative to both the EUR and USD.
To protect itself, Newgen Distribution employed a “layered” hedging program. They first calculated the total amount of foreign currency needed to secure vital imports in a year. Then, for the first 3 months, they hedged 75% of those payments. The following 3 months they hedged 50% of payments, then 25%.
This pattern of predictability helped the company avoid exchange rate losses of up to 10% over the pandemic, saving hundreds of thousands of SEK in potential losses.
Xerox, the well-known, US-based manufacturer of office equipment, operates in over 180 countries. In 2013, the organisation investigated its FX cash flows to deliver more predictable earnings by instating a corporate hedging programme, reducing the impact of currency volatility.
The objectives of this multi-stage initiative were as follows:
- Quantify the risk and the potential impact of FX volatility on revenue.
- Deliver more predictable earnings by aligning a corporate hedging programme with future FX cash flows.
- Improve the quality of FX forecasts while removing randomness from hedging decisions.
- Increase transparency so analysts could measure results against pre-agreed benchmarks.
To achieve this, Xerox tested several hedging strategies, settling on a rules-based, layered hedging model. The final model uses a data-driven decision-matrix to recommend the best FX tenures and hedge ratios to maximise income and reduce risk.
A systematic hedging programme such as this is helpful because finance teams can design it to ensure the system remains transparent and clearly understood by senior management. It describes a pre-agreed set of metrics on which all decisions are based, eliminating any reliance on guesswork.
This model’s benefits were immediate, and the project quickly proved its worth. As support for the initiative grew, Xerox installed better control and compliance procedures, hedge rates improved, as did transparency and the corporate bottom line.
How banks harm SMEs with predatory FX hedging practices
The European Central Bank (ECB), alongside the University of Geneva, released research detailing how major European banks earn hundreds of millions from overcharging SMEs for foreign exchange services.
Through an analysis of derivatives contracts across 200 European banks and almost 10,000 clients, researchers found smaller clients tend to pay higher rates for protection against swings in the market. In some examples, banks charged more complex clients 25 times more than standard market rates.
Researchers reported that banks collect an average of €638 million from discriminatory pricing practices. Most SMEs who engaged in contracts with said banks paid 0.5% in interest, while larger companies paid only 0.02%.
Of the SMEs investigated, more than 50% relied on a single bank to broker their deals, paying almost 14 times more in interest than those who source quotes from multiple brokers.
Faced with a choice, some SMEs choose to risk unpredictable market conditions rather than pay the high cost of FX derivatives offered by European banks.
This research isn’t the first time an independent organisation has tried to expose predatory bank practices in the FX industry. In 2019, the Association for Financial Markets in Europe (AFME) demanding the European Commission enforce greater transparency in FX markets. Using the Markets in Financial Instruments Directive (MiFID) legal apparatus as leverage, AFME representatives argued that FX rules initially intended for retail clients were unsuitable for participants in the wholesale market.
In response, many of Europe’s largest banks lobbied the ECB to remove any MiFID rules requiring them to disclose charges on the grounds that increased transparency was costly and of little benefit to customers. AFME countered that most banks already provide large market participants with more detailed information than regulators require under MiFID law.
CurrencyTransfer’s top tips to FX hedging
An FX hedging strategy doesn’t need to be complicated to be effective. Here are some ways you can implement a robust hedging strategy:
- Identify your total FX exposure – Be sure to factor in pending payments, transfer costs and conditional factors when forecasting your currency needs.
- Understand what factors affect exchange rates – Keep a close eye on interest rate decisions, inflation rates and US unemployment figures. These can help you determine when it may be prudent to re-evaluate your FX strategy.
- Talk to a payment specialist to determine your best strategy – Be wary of following generic advice found online. Rather, work alongside an experienced financial guide to help create a suitable strategy.
At CurrencyTransfer we work with clients to help create simple and effective forex strategies on a daily basis.
Below are some of our hedging solutions:
Firms can book a forward contract to safely budget their expenses by reducing the risk of currency fluctuations. SMEs can purchase a set amount of currency in the future using today’s rates. Brokers will immediately purchase the agreed-on amount and hold it in reserve until the payment date.
Currency options are similar to forward contracts in that they give businesses the ability to exchange foreign currency at a set time and at a predetermined price. Unlike forwards contracts, businesses are not obliged to complete the purchase should their situation change. This tool is available to use from your CurrencyTransfer platform.
Alternatively, businesses may book a market order to automate their currency risk management. This tool allows them to automatically book an international payment when the exchange rate has hit a range within which they can comfortably operate.
Contact us today for a free consultation. Our team of experts will help you design bespoke financial plans tailored to suit your unique needs.