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Got to be certain?

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Published: 09 Jul 2013 Updated: 14 Sep 2022 Update History

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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:

  1. 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.
  2. 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.

Figure 1: Risk in a contract time line
Figure 1: Risk in a contract time line

Risk responses

Having identified our risks we can then think about some responses. Hedging is by no means the only option. It is not an appropriate response to deal with economic risk, at least in the long term. Dealing with economic risk might be better addressed by relocating production to a different currency zone, where costs are lower or the currency cost base matches that of either or both of our customers and competitors. Auto manufacture is a classic example of relocating to match suppliers and/or customers.

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.

Will Spinney Finance & Management magazine, July/August 2013

Difficult areas

The common view of foreign exchange risk as only requiring a hedge to mitigate is too simplistic. Other difficult areas include the base cost of capital assets, which will move with the exchange rate, if not in the same currency as the purchaser. Airlines buying aircraft, for example, will be particularly sensitive to the rate at which they buy the US dollar against the currencies in which they receive their cashflows and the amounts involved are significant – an Airbus A380 has a list price of £390m.

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

Hedging is the fixing of an exchange rate and hence giving certainty to the value of a foreign currency cashflow. The most common instrument to achieve this is a ‘foreign exchange forward’ (most often referred to as a ‘forward’), where one company’s foreign currency cashflow is exchanged with a counterparty’s cashflow at a rate agreed beforehand.

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

Another common type of instrument is an option. This instrument can give the best of both worlds because it avoids the opportunity cost altogether. In the last example, if an option was bought at a ‘strike’ of £1 = €1.15 and then the rate moves to £1 = €1.20, the option can be allowed to lapse and the euro bought at £1 = €1.20. This, unsurprisingly, has a cost, called a premium, which is payable up front and is higher when the risk is higher. The premium would be a fraction of the total option value, however.

Managing exposures through cash and borrowing can be better for small companies

Will Spinney Finance & Management magazine, July/August 2013

What do companies do?

While it is generally the larger companies that engage in hedging of any sort, mainly because of the need for ‘market-sized’ transactions and specialists who understand the risks and the markets, smaller companies should also assess their risks. Managing exposures through cash and borrowing can be better for these businesses.

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?

There is no one right answer to these issues and different firms tackle their problems in different ways. However, hedging is best viewed as buying time for the hedger to change the business model. No hedge lasts forever but a hedge can be made which gives management time to react, compared with how quickly a moving exchange rate can destroy a business model.

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.

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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.
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