5 October 2018
Protection against currency risks
U.S. mid-term elections, trade wars, Brexit: how do you hedge against exchange rate risks?
The continuing uncertainty surrounding the precise terms of Brexit is causing great volatility in the pound sterling. In addition, the ongoing trade war between America and China is having an impact on the dollar and renmimbi exchange rates, as well as on other currencies.
Protection against such exchange rate fluctuations is perfectly possible, but you probably have many questions about this. Do you need to hedge against it or not? And especially, if you do opt for hedging, what are the possibilities?
This is how you can hedge against the risk
Fortunately, there are a lot of instruments in place to protect you against exchange rate movements. The most common one is the forward exchange contract. This simple method works as follows:
- Say you will be receiving a payment in foreign currency in three months' time; you can enter into an agreement with the bank whereby you sell a set amount of foreign currency on a specific date, for example at a predetermined exchange rate in euro.
- The price in the forward exchange contract is determined on the basis of the spot price and of swap points, which are the interest rate difference between the foreign currency and the euro at the time you conclude the forward exchange contract.
- On the maturity date, you will sell the foreign currency you receive at the forward rate specified in the forward exchange contract, regardless of the exchange rate at that time. This means you do not have to worry about a decrease in the value of the foreign currency between the date of hedging and the time of payment. The other side of the coin is that with a forward exchange contract you will not be able to benefit from a possible upswing in the value of the foreign currency during the same period.
The forward exchange contract is the most common instrument for hedging against exchange rate risks, but it is certainly not the only one. Your banker can offer you the best solution for your specific situation.
Hedging or win some, lose some
Is currency hedging an absolute necessity for every exporter? The answer is no. Some companies are very deliberately adopting the ‘win some, lose some’ strategy. Please take the following factors into account when making your decision:
Your profit margin
Profit margins are very industry-dependent. Those who work with very small profit margins can quickly see their profitability disappear with regularly occurring exchange rate losses of 5 or 10%. But if, for example, your margin is around 30%, you can easily cope with a fluctuation of that magnitude.
The size of your turnover in foreign currencies
How many currencies present a risk for you? And what share of your overall sales is in a foreign currency? The larger that share, the great the effect of an exchange rate movement, and so the better you need to hedge against it.
The term of your quotation phase
If there is usually a long period of time between your quotation and the signing of the contract, you are exposed to exchange rate risks for a long time. Moreover, it is best not to hedge with a forward exchange contract during the quotation phase, because even if a deal is not reached with your customer, you are still obliged to honour the contract. In such a case, you can consider an option. This will protect you - subject to payment of a premium - against an unfavourable price change, but you retain the right to waive the hedge if the contract does not go ahead.
The payment terms
Do your customers get generous payment periods or do you sometimes allow them to postpone payment? In that case as well, your company will be exposed for a much longer time to possible price fluctuations.
The strategy of your competitors
Suppose that you hedge your risks, but your competitors don’t. Your competitor will benefit from a strengthening of the foreign currency during the term of your forward contract. In the event of a weakening of the currency, on the other hand, you will have a competitive advantage.
Talk to your bank
If you have a significant turnover in a foreign currency and you are exposed to exchange rate fluctuations for a long period of time, do not hesitate to involve your banker in time. Together with you, he will make a tailor-made analysis of your situation. For example, you could create a buffer for potential falling exchange rates so that the profitability of your exports to the UK will not be eroded as a result of a fall in currency value.