Business is full of financial risks such as cash flow shortages, changes in interest rates or commodity prices and depreciation of assets. Currency exchange is also a major risk for anyone trading in international currencies, but as the saying goes ‘with great risk comes great reward’. The key to success lies in mitigating the risks and extracting as much reward as possible.
Accru Felsers currency exchange providers, World First, provide an overview of the global currency market and explain some of the basic concepts around hedging.
The global currency markets are the largest in the world, with some $4.9 trillion traded every year, according to the Bank for International Settlements. That works out at around $13.4bn every single day or, put another way, $155K every single second! Moves can be volatile with shifts in values of 2-8% over the course of a month not at all uncommon. If businesses are dealing in competitive markets or have very tight margins on product lines, then these moves can easily erode profit margins, no matter how innovative or compelling the product line or offering is.
Protecting yourself from these fluctuations or ‘hedging’ these risks is a natural, sensible and necessary part of maintaining a business that deals internationally. Of course, as currency hedging specialists this seems obvious to us as much as simple case law will to a lawyer.
If there was one golden rule that you would ascribe to the process of hedging it would be ‘hope is not a hedge’. No matter how long you have been dealing in currency markets there will be a hope that the rate will become more favourable for you and your business over time, and before you know it, the business is under water. Looking ahead at the known or fixed costs and ensuring that these costs are covered, is essential to your business’ success.
You can fix these costs in AUD at the time of setting the budget by using either a ‘forward contract’ or a ‘currency option’. Both are contracts that allow businesses to hedge an amount of currency at a given rate for some point in the future, but differ in their flexibility.
A ‘forward contract’ will give a company a definitive worst case rate that nobody can take away from them – perfect for hedging – but will not allow them to benefit from any advantageous moves that the currency may make in the interim period.
A ‘currency option’ provides the company with that worst case rate, but the flexibility to take advantage of beneficial moves also.
Both of these products are completely bespoke and can be altered depending on the needs of the business. The requirements of different companies are as individual as the people within them, so if you only need protection for five months, alternating months or in exotic currency pairs for varying amounts – all can be catered for.
Some would try and paint these contracts as gambling on the rate and/or making unnecessary, speculative moves in the currency markets. This is nonsense of course, as hedging represents the complete antithesis of gambling – certainty.
As a recent example the AUD/USD price dropped almost 8% within the space of four weeks (5 September – 3 October). Say you were paying a supplier in the US, and needed to transfer $AUD100,000. On 5 September, that $100,000 was worth $93,700 (based on a 0.937 AUD:USD exchange rate), but by 3 October – only four weeks later – that same amount of money was worth $86,700. That’s $7,000 less, and all because of the fluctuating nature of the exchange rates.
During this period we saw a number of businesses that benefited from hedging their exposure at these higher levels for a particular amount of time, prior to the decline. Their competitors who didn’t hedge at these levels were therefore buying their stock at a higher price – and in this highly competitive market, sustainable bottom lines savings as demonstrated above could be the difference between your business turning a profit or otherwise.
If the given currency were to rise above the ‘protection’ or ‘hedge rate’ in an Option Contract, then you have the right to buy at those spot levels up until a particular level. For example, by being protected at 0.93c these clients will not exchange at a rate lower than this during the contract and if the AUD/USD was to rally to 0.95c, they can transact at this better price.
Regardless of whether markets are calm or a storm is running through them, hedging is a necessary and simple way of transforming the risks of the largest market in the world into rewards and relative certainty for your business.
The author of this article, Ellis Taylor, is Deputy Head of Sales, Corporate Foreign Exchange for World First Pty Ltd. You can contact Ellis directly on (02) 8298 4903 or Ellis.Taylor@worldfirst.com.