Our OFXperts share some considerations to help you decide
To the uninitiated, hedging might seem like something that happens on Wall Street, both impressive and terrifying at the same time. But it shouldn’t be scary, you might even already be using hedging strategies in your everyday life.
Put simply, hedging means protecting yourself from a future change in price. In foreign exchange, it works by taking a position that prevents you from losing out if the currency market moves against you. To do this, businesses can utilise a product called a Forward Contract, which locks in an exchange rate for an agreed amount that can be used on a date up to 12 months in the future.
Hedging is an excellent strategy to help individuals and businesses protect themselves from rates moving against them when they know they need to make a currency transaction at a set point, or even on a regular basis. But not every company will see the benefit, especially as there are some costs involved in creating this protection strategy.
Not sure if hedging is right for your business? Here, our OFXperts outline some considerations to help you decide if this is the right approach for you.
Are your payments regular or ad hoc?
Jake Trask, one of our OFXperts, said: “Hedging is a strategy suited to a company that has a regular need to buy goods or services from overseas rather than someone who buys on a very ad-hoc basis.” If your business buys goods or services ad-hoc, then you have more flexibility in the payments you make. So, locking yourself into a rate for a period of time prevents you from taking advantage of beneficial market movements.
Mr Trask said: “A business should look to hedge when it has finalised an order to buy goods or services and it needs to mitigate the foreign exchange risk in buying those goods or services. But you need to be sure that the goods or services are definitely going to be delivered by the vendor. So, signing contracts is very important.”
For example, if you “end up hedging on a hunch”, as Mr Trask puts it, based on an estimate of your foreign exchange needs in the future, then you have committed to buying an amount of currency at a locked-in rate which could leave you with a considerable loss if the contract is not fulfilled.
Are you comfortable if you miss out on a better rate?
If you have chosen to use a Forward Contract to fix a rate, you need to accept that if currency market volatility worked to your advantage, you would still have to abide by that contract, said Mr Trask. “Companies should be happy to pay a fixed rate for the duration of a contract. Even if the market rate pushes higher, they are still obliged to complete the Forward Contract.”
What if you want the best of both worlds? “Some clients will do a combination of hedging half their exposure and doing half at the ‘spot’ or ‘on the day’ rate to potentially take advantage of upticks in the rate.” The real benefit for companies who hedge in this way is that they have set currency costs for a period of time. It may mean losing out if currencies move in your favour, but you will also be reducing the risk of any costly surprises.
Is hedging the right strategy for the currencies you work with?
Some countries suffer much more political instability and therefore likely to have much higher currency volatility. If your business is trading with a currency that could be subject to extreme swings, the risk of currency moving against you is amplified.
But no matter what currency pair you need to trade in, whether volatile or more stable, shifting exchange rates could still impact your bottom line, and you can use hedging as a strategy to reduce the risk you are taking.
What is your business’s attitude to risk?
Ultimately, the hedging strategy that’s right for your business will depend on the attitude (from the top down) to risk-taking and sensitivity to exchange rate shifts.
Remember, hedging is very much like an insurance policy – you may not benefit from it, but if something goes badly wrong, you will be very glad it is there.
Seek professional assistance
Managing currency risk is a specialised area. If you don’t have the desire or skills within your business to formulate a strategy, it’s wise to seek outside help.
OFXperts can help you to identify opportunities in the market, develop a strategy to stay ahead of currency volatility—and if time allows, wait for better rates before you choose to lock in a transfer. Contact us today.
- Consider your business profit margins and if a rate fluctuation could wipe out your profit
- Consider using hedging if currency fluctuations will impact the profitability of your business (For example, if you are operating within small margins)
- Use hedging as a long-term strategy. What are your known FX needs and how can you reduce risk?
- Think of your Forward Contract as insurance and accept that the ‘spot’ or ‘on the day’ rate may be better than the rate you have fixed
- Watch the markets to take advantage of any rates in your favour outside your hedged amount
- If your agreements or contracts aren’t watertight and the purchase or deal fall through, your business will still need to fulfil the Forward Contract
- You could miss out on market movements in your favour by hedging every part of your exposure
- You don’t necessarily get the full benefit of hedging if your FX needs are adhoc and unpredictable, rather than recurring
IMPORTANT: The contents of this blog do not constitute financial advice and are provided for general information purposes only without taking into account the investment objectives, financial situation and particular needs of any particular person. UKForex Limited (trading as “OFX”) and its affiliates make no recommendation as to the merits of any financial strategy or product referred to in the blog. OFX makes no warranty, express or implied, concerning the suitability, completeness, quality or exactness of the information and models provided in this blog.