Hedging Strategies For Mitigating Forex Risk – This practical guide by Finance Expert Paul Ainsworth draws on 30+ years of experience as a CFO of multinational corporations to set out a list of options that companies face in order to address foreign exchange exposure and manage risk effectively.
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Hedging Strategies For Mitigating Forex Risk
Exchange rate change is a daily occurrence. From the vacationer planning a trip abroad and wondering when and how to get the local currency to buying and selling multinationals in multiple countries, the impact of getting it wrong can be substantial. That is why foreign exchange risk management (or forex risk management) is important.
How Can We Mitigate Foreign Exchange Risk For Infrastructure Investments?
During my first overseas assignment in the late 1990s and early 2000s, I came to work in Hungary, a country that experienced a major change after the regime change of 1989, but one in which foreign investors have willingness to invest. The transition to a market economy generated significant financial change, as the chart below shows. The Hungarian Forint (HUF) lost 50% of its value against the USD between 1998 and 2001 and then regained it all at the end of 2004 (with significant changes along the way).
With foreign currency trading in HUF in its infancy and therefore hedging very expensive, it was at this time that I first experienced the impact foreign currency fluctuations can have on the P&L. In the trading currency of USD, the results can jump from profit to loss only on the basis of exchange movements and it introduced me to the importance of foreign currency understanding and financial risk management.
The lessons I learned have been invaluable throughout my 30+ year career as a CFO of large, multinational companies. However, I see many cases still today of companies that fail to reduce foreign exchange risk and suffer the consequences as a result. For this reason, I think it is useful to create a simple guide to those who are interested in learning about the ways people can face financial risk, and a menu of companies that face it, sharing some of the experiences of self in the way. I hope it is useful.
This is the simplest form of foreign currency exposure and, as the name itself suggests, arises because of the actual business transaction that takes place in foreign currency. The exposure occurs, for example, due to the time difference between the right to collect money from a customer and the actual physical receipt of the money or, in the case of payment, the time between the placing of the purchase order and the settlement of the invoice. .
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Example: A US company wants to buy equipment and, after receiving quotes from several suppliers (both domestic and foreign), has chosen to buy in Euros from a company in Germany. The materials cost €100,000 and at the time of placing the order the €/$ exchange rate was 1.1, meaning that the cost to the company in USD was $110,000. Three months later, when the invoice was due for payment, the $ has weakened and the €/$ exchange rate is now 1.2. The cost to the company to settle the same € 100, 000 payment is now $ 120, 000. The trade show has resulted in an additional unexpected cost to the company of $ 10, 000 and it may mean that the company may have buy equipment at low cost. from one of the suppliers’ selection.
Sometimes known as exchange rate exposure, this is the translation or conversion of the financial statements (such as a P&L or balance sheet) of a foreign subsidiary from its local currency into the parent’s reporting currency. This occurs because the parent company has reporting obligations to shareholders and regulators which require it to provide a set of accounts in its financial reporting for all its subsidiaries.
Following on from the example above, let’s assume that a US company decides to set up a subsidiary in Germany to manufacture equipment. The subsidiary will report its expenses in Euro and the US parent will translate those statements into USD.
The example below shows the financial performance of the subsidiary in the local currency of the Euro. Within one and two years, he has grown the revenue by 10% and achieved some productivity to increase the cost to 6%. This results in an impressive 25% in net income.
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However, due to the impact of exchange rate movements, the financial service looks very different in the parent company’s reporting currency of USD. Over the course of two years, in this example, the dollar has strengthened and the €/$ exchange rate has dropped from about 1.2 in Year 1 to 1.05 in Year 2. The currency performance in USD looks very bad. Revenue is reported as falling by 4% and net income, while showing growth, is only by 9% rather than 25%.
The opposite effect can certainly occur, which is why, when reporting financial performance, you’ll often hear companies quoting both a “reported” number and a “local revenue” for some key metrics such as revenue. .
This type of foreign exchange exposure is caused by the impact of unexpected and unpredictable currency changes on the company’s future cash flows and market value, and is long-term in nature. This type of exposure can affect long-term strategic decisions such as where to invest in production capacity.
In my Hungarian experience mentioned at the beginning, the company I worked for transferred large amounts of energy from the US to Hungary in the early part of the 2000s to take advantage of the low production cost. It was more economical to manufacture in Hungary and then ship the product back to the U.S. However, the Hungarian Forint then strengthened significantly over the next decade and erased many of the forecast price gains. Exchange rate fluctuations can greatly affect a company’s competitive position, especially if it does not operate or sell abroad. For example, a US jewelry maker that sells only locally still has to deal with imports from Asia and Europe, which can be cheaper and therefore more competitive if the dollar is particularly strong.
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The first question to ask is whether to bother trying to reduce the risk at all. It may be that a company accepts the risk of borrowing as a cost of doing business and is prepared to deal with the potential loss of earnings. The company may have high enough profit margins that provide a buffer against exchange rate fluctuations, or they have a strong brand / competitive position that they are able to raise prices to offset adverse movements. In addition, the company can do business with a country whose currency is pegged to the USD, although the list of countries with regular pegs is small and not significant in terms of trade volume (with the exception of Saudi Arabia which has had a peg in place with the USD since 2003).
For those companies that choose to manage foreign exchange risks, the tools available range from very simple and low cost to more complex and expensive.
Firms in a strong competitive position selling goods or services with a single brand may be able to trade in a single currency. For example, a US company may be able to insist on invoicing and paying in USD even when operating abroad. This passes the exchange risk to the local customer/supplier.
In practice, this can be difficult because there are some costs that must be paid in local currency, such as taxes and salaries, but it can be done for a company whose business is primarily online.
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Many companies managing large infrastructure projects, such as those in the oil and gas, energy, or mining industries are often under long-term contracts which may involve a significant foreign currency share. These contracts can last for several years and the exchange rates at the time of signing the contract and set the price can then change and risk profit. It may be possible to write foreign exchange clauses into the contract that allow money to be recovered in the event that exchange rates deviate more than the agreed amount. This obviously then passes any foreign exchange risk to the customer/supplier and will need to be negotiated as another contractual clause.
In my experience, these can be a very effective way of protecting against foreign exchange fluctuations but require the legal language in the contract to be strong and the references to which the exchange rates are measured to be clearly stated. These clauses also require that a regular review guarantee is implemented by the finance and trading groups to ensure that once an exchange rate clause triggers the necessary process to recover the loss will be implemented.
Finally, these clauses can lead to difficult business discussions with customers if they are triggered and often I have seen companies choose not to force to protect a customer relationship, even if the time fits with
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