Protecting Cash Flow – To Hedge Or Not To Hedge
8 October 2021
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By Matt Blackwell, OMF
The impact of a volatile foreign exchange market on import and export businesses can be significant, especially in a market economy largely dependent on international trade. Anticipating change and managing risk in order to counter the unpredictable is as critical as insuring our house, health or car.
The rise and fall of the exchange rate is nothing new. But we’re now seeing signs of currency markets becoming increasingly volatile, highlighted recently by the Swiss franc falling almost 30 per cent in one day. This type of event illustrates the extent of changeability in the foreign exchange markets. It also reinforces the need to have a prudent plan in place for managing risk when buying or selling currencies.
Accepting and managing volatility
Whether you’re an exporter distributing products into international markets, or a manufacturer importing materials for production, the value of the New Zealand dollar can wreak havoc on your profit margin. This could potentially leave your business exposed.
New Zealand has a floating exchange-rate, meaning the rate can swing dramatically at times. While the value of the New Zealand dollar has been unsustainably high — benefiting New Zealand importers —our exporters have really felt the pinch.
Conversely, over the course of 2015, the value of the New Zealand dollar has dropped considerably. As economic performance has deteriorated and inflation has remained low, New Zealand importers have watched on anxiously for further decline. On the other hand, exporters have been able to breathe a sigh of relief because their margins have begun to look much brighter and healthier.
Protecting cash flows with hedging techniques
We’re all conditioned to pay premiums to insure our houses, our cars and even our health. Most of us, at the end of each year, thank our lucky stars that we haven’t needed to call on our insurance — we go forth and happily pay our premiums again for the following year.
Foreign exchange risk should be no different, and the traditional hedging techniques described below can provide a flexible way to protect cash flows.
Why you should hedge
Hedging is a way of spreading risk to limit or offset the possibility of loss arising from (currency or commodity) price fluctuations. Usually this is done through making an investment in a related security that you expect to perform in the opposite way.
If you’re lucky enough to operate in a market where you can pass on costs to your consumers — such as the airline, utilities or food distribution industries — then you probably don’t need to consider hedging. Similarly, if your core product moves fluidly with the exchange rate, for example petrol, you can probably remain unhedged.
Beware, though, your competitors could steal a march on you if they may have measures in place to counter volatility in the markets. If you don’t have a hedging strategy, your profitability and cash flow could suddenly be eroded by a change in the value of the New Zealand dollar, putting you at a competitive disadvantage.
How to hedge
A strategic approach to hedging should always include the question of ‘how to hedge’ as opposed to ‘should I hedge’.
1. Buy up front
A common approach to hedging is to use forward rate agreements or a currency forward. This locks in a price on currency for future delivery based on the prevailing ‘spot rate’. But using this method of buying up front can expose a company to a number of risks.
If orders get cancelled or sales are lower than forecast, or if the price of core materials fluctuates, then hedging may see you overly covered. When this happens a company has two options, both less than desirable. It’s either forced to close out its foreign exchange positions at current market rates, or roll its positions (and the loss) forward to a future date.
2. Do nothing
Another approach to managing foreign exchange is to actively do nothing, and only exchange currency at current market rates. This, of course, leaves the company completely exposed to any adverse exchange rate fluctuations.
Buying up front or doing nothing are two extreme approaches to the foreign exchange markets. Both strategies, ironically, tend to be adopted by companies that say they don’t want to ‘take a view’.
3. A balancing act
An alternative, more balanced approach to hedging is to begin with a risk-neutral starting point of 50 per cent hedged and 50 per cent unhedged. From here, a hedging strategy can be built that combines forward rate agreements and foreign exchange options. This should provide a level of assurance balanced with the flexibility of being able to take advantage of any favourable currency moves.
What’s right for your business?
Predicting foreign exchange movements is notoriously difficult and even the ‘experts’ can get it wrong. If you deal with foreign currency, you should be aware that volatility can potentially affect profitability.
A proactive hedging strategy can be vital to remaining competitive in the global business environment. Using a reputable broker that understands the unique needs of your business can help you protect your company’s bottom line.
FLOATING: a floating exchange rate is when the value of a currency is able to fluctuate freely, in response to foreign-exchange markets.
FIXED: where the value of a currency is tied to that of another currency.
FOREIGN EXCHANGE POSITION: a binding commitment to buy or sell foreign currency.
FOREIGN EXCHANGE OPTIONS: a contract that gives the right but not the obligation to exchange money from one currency into another, at a pre-agreed exchange rate on a specified date.
MARKET RATE: states the rate at which one currency can be exchanged for another on the open market. It’s the purchase price between two currencies, quoted as a pair, such as the NZD/USD (the New Zealand Dollar and the US Dollar). Exchange rates fluctuate based on economic factors and political events.