Hedging currency is still one of the most popular forms of risk in normal trading transactions, but it’s by no means the only one. Will Spinney considers the options.
When it comes to commercial risks arising in foreign exchange, many treasurers hedge and then make the required accounting transactions – often for economic reasons. But what are the wider concepts and issues around foreign exchange risk?
As an example of the sort of risks businesses face, consider the two following examples:
- An exporter quotes a price in the currency of his customer, say Brazilian reals, while having costs in sterling. The quote remains valid for some time, during which time sterling climbs against the real. The customer orders the goods at the old set price that now delivers 5% less in sterling terms than when the quote was provided.
- A transport operator needs to buy assets, which are quoted to him in a foreign currency. The rate at which the currency is bought changes the base cost of the assets and may disadvantage the purchaser compared with another operator in the field.
We could also look at this personally.
Say we are going to visit the US soon
and need to buy dollars. We have a risk
on the sterling costs of those dollars
until we have bought them. We can
choose to buy them at any time before
our trip; until they are bought we don’t know exactly how much the trip will cost. In fact, we could also borrow
those dollars for our trip, deferring the
conversion to our home currency.
The amounts involved for a single
trip would not be very significant, but
suppose we want to go there year after
year and rent an apartment. How far
does our risk extend?
If we take the time line of a typical
contract with foreign exchange rates
involved, we can look at the risk as
several different types (see figure 1).
Economic risk is the risk that we
are competitive in the first place and
that we can actually bid. The exchange
rate may make us more expensive than
a foreign competitor, for example.
When management starts thinking
about whether to bid, it has an exchange
rate in mind. This tends to remain a
key part of the conversation over the
life of the contract. So a calculation of
expected profit might be based on this
rate. We could call this pricing risk.
When a bid is actually made, or price
list prepared, the company has
committed to a particular price without
knowing whether it will get the business
or not. This is pre-transaction risk
and the risk is of a contingent nature.
Finally transaction risk arises
when we are fully certain of all
the cashflows.
Another type of foreign exchange
risk that arises is called translation
risk, where sales, cashflows, assets and
liabilities are translated at period ends.
Generally these types of risks are not hedged against, but many treasurers
will manage the currency composition
of their net cash or debt position. This
can reduce the risks of credit ratios,
such as leverage or cashflow ratios,
deteriorating.
Economic risk is all about the
business model and its cost structure,
whereas pre-transactional and transaction
risk is all about the tactical aspects of
treasury management and hedging.
Risk responses
Another way of dealing with currency risk might be to shift the supplier base to a different currency zone to achieve a more natural hedge, so that currency cashflows in and out are better matched. This sounds simple but can lead to restriction of choice and selecting a sub-optimum supplier. Any monies saved through removing the currency risk may of course be wiped out by other unforeseen costs.
For pre-transaction exposure, which is a difficult risk to manage, think about a bank. It will only hold a price open for a few seconds. Contrast that with a company that has issued a price list or tender valid for several months.
Finally, hedging is used for the more certain transactions, akin to fixing any other kind of business cost, such as rent or any other supply for a contract.
Hedging is used for the more certain transactions, akin to fixing any other kind of business cost, such as rent or any other supply for a contract.
Difficult areas
Some businesses have models that do not easily fit our contract timeline seen in figure 1. Perhaps they make confectionery for export into retail markets. The retail price of the confectionery cannot be changed quickly according to the exchange rate and the pricing decisions were made many years ago, perhaps by previous managers. This type of problem is very common.
Some businesses are very complex and even finding out the certain cashflows can be difficult. A good order system in a multinational might give the short-term cash inflows but purchasing decisions may not follow for several months.
Instruments and hedging
Fixing instruments
The rate can be agreed as far in advance as required (within reason) but most commercial hedging of this sort is done up to about 12 to 18 months in advance of the settlement date when cashflows are actually exchanged. Some firms engaged in long-term capital goods transactions may want to agree cashflow exchanges much further into the future, however.
The usual counterparty for a forward is a bank but other counterparties increasingly compete in this area of foreign exchange. Unless margin (cash due to or from the counterparty as the forward changes in value) is paid, forwards need a credit facility. There are alternatives to forwards: futures can be used to achieve the same effect, and are taken out on exchanges. In addition, economic equivalence to forwards can be achieved by buying or selling a currency now (called ‘spot’) and depositing or borrowing that foreign currency, respectively.
A question often asked of treasurers is the ‘cost’ of hedging. Unfortunately, this does not have a simple answer. Basically, the cost can be simply based on spreads charged by banks and other providers, but this ignores the opportunity cost, which should also be included in the calculation. An opportunity cost can arise when fixing instruments are used; the following example will show this.
Imagine you buy a transport asset such as a train or bus from a European supplier and you fix the exchange rate in advance at £1 = €1.15, with a forward. You have achieved certainty of costs in sterling. But if a competitor wanting the same asset buys the euro at a different time at £1 = €1.20, then he has paid only 96% of your cost and can charge less for use of the asset than you. The cost of hedging should include the opportunity cost of fixing at a better rate than the one which you have hedged at. The certainty sought might in fact cause higher risk in situations such as this.
Options
Managing exposures through cash and borrowing can be better for small companies
What do companies do?
If the cashflows are certain, as in transaction exposure, most firms hedge with forwards. Where there is any uncertainty as to the cashflows, with unknown sales forecasts for example, firms often hedge a percentage of expected sales. So certain sales invoiced might be hedged 100%, then 80% for the next period, then 50% for a further period and so on.
Contingent exposures such as tenders and price lists can be managed in this way or more ideally with options.
The perfect hedge?
Foreign exchange risk that arises in the normal course of trading is very much a commercial issue and the treasurer must understand his business, talk to managers and make sensible decisions to reduce risk and protect their business model.
Download pdf article:
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Got to be certain?
Finance & Management Magazine, Issue 212, July/August 2013
About the author
Will Spinney FCT is associate director of education at the Association of Corporate Treasurers.
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Update History
- 09 Jul 2013 (12: 00 AM BST)
- First published
- 14 Sep 2022 (12: 00 AM BST)
- Page updated with Related resources section, adding further reading on foreign exchange risk for businesses. These new articles and ebooks provide fresh insights, case studies and perspectives on this topic. Please note that the original article from 2013 has not undergone any review or updates.