If You Aren’t Hedging Exchange Risk, It May Be Time to Rethink Your Strategy
Author: Kalli Heupel, Director, Foreign Exchange
Uncertainty is always a factor when trading in foreign markets. Currency fluctuations are common and unpredictable, putting companies at risk when transacting in foreign currencies. Fortunately, there are several ways to bring more certainty to the process by hedging exchange risk.
Below, we discuss the most common instruments and how they may help you reduce your exposure during foreign trade transactions.
Why Trade in Foreign Currencies
As companies negotiate international contracts, it may seem most favorable to conduct business in your home currency. However, there are some drawbacks to this approach.
When transacting in home currencies, businesses pass the risk to their suppliers, many of whom will levy additional costs to cover the risk they face. For example, it is common for suppliers in Mexico to account for market fluctuations by marking up the price of goods as exchange rates become less favorable.
In this situation, paying in the foreign currency makes it possible for companies to negotiate with suppliers in the country where they are doing business, which may drive down the costs associated for all.
There may also be advantages for a company to price their foreign customers in the customer’s local currency. The sales price could be easily measured against local competitors since foreign customers can weigh their options with an apples to apples price comparison.
However, the company also assumes risk when conducting business in a foreign currency. Most of the risk involves fluctuating exchange rates. A contract negotiated at $1 million, for example, could end up returning less if the exchange rate changes unfavorably.
To protect profitability, companies may use some form of hedging, using financial instruments to reduce the associated risks.
Understanding Hedging Instruments
When it comes to international trade, there are several ways to hedge exchange risk, and the advantages differ depending on the needs of the business. Hedging offers a multitude of benefits to the companies that utilize them, including the ability to offer predictable cash flows, the ability to lock in profit margins and most importantly, risk reduction.
A spot contract allows a company to purchase currency now for payment to be made usually one to two days in the future. In this scenario, the business benefits from a simple exchange of currency at the prevailing exchange rate.
Spot contracts are particularly beneficial if a company needs to make an immediate payment, which is typically done via wire transfer. Initiating a spot transaction is simple and can even be completed under existing agreements with your local financial institution.
However, a spot contract can be risky at times, as it does not protect the company against long-term currency fluctuations from when a transaction is agreed upon to when funds are sent.
A forward contract allows a company to lock in an exchange rate now for settlement on a specified future date. This contract is purchased through a third party, usually a bank, locking in the rate at the time of the sale. Currency doesn’t change hands until the value date or the end of the contract.
Companies benefit by knowing exactly how much they will pay or receive from a transaction. However, a forward is a contractual obligation, so if the contract ends up not being needed, the company will have to liquidate at the current market and realize the gain or loss depending on which way the currency moved.
Non-deliverable forwards are used in situations where there is no active forward market to provide protection against adverse currency movements during the term of the contract. A non-deliverable forward is like the forward contract in that an exchange rate is agreed upon ahead of time for a future date. However, instead of purchasing currency on a set date, both parties agree to settle the difference between the rate established at the contract’s inception and the effective spot rate on the fixing date.
Countries where a non-deliverable forward may be utilized include Brazil, Taiwan, South Korea, and China. It’s important to note that a non-deliverable forward does not provide protection against adverse currency movements at the time the difference is paid.
Lastly, a currency option allows a company to buy or sell currency at a specific rate on or before a specified date but does not obligate them to do so. This type of hedging instrument provides the company with flexibility and the potential for unlimited upside on its exposure but may require an upfront cost. If the spot rate in effect on the contract’s settlement date is more favorable, then the business can choose not to exercise the option’s exchange rate and buy or sell at the current market rates.
Keep in mind, a currency option may require a payment of an upfront premium that will need to be taken into consideration when determining the underlying exposure.
Hedging Instruments in Action
To demonstrate how hedging instruments can reduce the risk of doing business in foreign currency, let’s follow hypothetical Company XYZ as it utilizes one of the available hedging strategies.
Company XYZ is a U.S. manufacturer selling equipment to a customer in Mexico. The terms of the deal are as follows:
Value of the equipment: $1 million USD, but the company wants to offer a local price to the customer in Mexico
Exchange rate used: 20.00 USD/MXN (1.00 USD = 20.00 MXN)
Total Price MXN: 20 million MXN
Terms of the 20 million MXN invoice are:
- 25% Down payment – 5 million MXN
- 75% Due upon delivery (60 days from today) – 15 million MXN
If Company XYZ were to sell the equipment to the Mexican company without hedging their exposure under the terms above, the company’s bank would receive a deposit for 5,000,000 MXN on January 15th. With an exchange rate on that day of 19.75, Company XYZ will receive $253,164.56 in U.S. funds.
Two months later, when the remaining 15,000,000 MXN is received by the company’s bank, the exchange rate on that day is 20.50. As a result, Company XYZ will receive $731,707.32 in U.S. funds.
In total, the Mexican customer still paid their full 20 million MXN invoice, but since Company XYZ did not hedge to protect their receivable, and the value of the Mexican Peso declined, the business only received $984,871.87 USD.
Now let’s take a look at how FNBO would help Company XYZ protect against fluctuating exchange rates by utilizing common hedging instruments.
- On January 14th – Company XYZ locks in the following contracts with FNBO
- Spot Contract (delivery the following day) 5,000,000 MXN at an exchange rate of 19.75 = 253,164.56 USD
- Forward Contract (60 days from today) 15,000,000 MXN at an exchange rate of 20.08 = 747,011.95 USD
- On January 15th – FNBO receives the 5,000,000 MXN and converts it at the contract rate of 19.75 = 253,164.56 USD
- On March 15th – FNBO receives the 15,000,000 MXN and converts it at the contract rate of 20.08 = 747,011.95 USD
In total, the Mexican customer paid their full 20 million MXN invoice, and because Company XYZ hedged their receivable, they received $1,000,176.51 in U.S. funds. This hedge brought predictability to their cashflows and ensured they received the 1 million USD they were anticipating.
When trading in foreign currency, it’s important to guard against currency fluctuations and other risks. Your financial institution is well versed in hedging instruments, making them an ideal partner when it comes to developing a case-by-case hedging strategy to help promote the best outcomes for your business.
The articles in this blog are for informational purposes only and not intended to provide specific advice or recommendations. When making decisions about your financial situation, consult a financial professional for advice. Articles are not regularly updated, and information may become outdated.