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By Jennie Stokes, GPS
CAPITAL MARKETS, FX Sales & Trading
In this era of market
globalization, it is virtually impossible to avoid being
exposed to some form of foreign currency risk. Whether your
company is exposed directly in the form of foreign currency
receivables or payables, or indirectly, through an overseas
competitor’s pricing agreements, identifying and taking steps
to manage these risks before they impact your bottom line has
become crucial to running an effective business.
Unfortunately, many companies have misconceptions about FX
hedging and don’t explore it as a risk management technique.
Today we’ll look at three of the most common objections to
hedging and separate the facts from the myths.
Is Hedging FX Speculative?
We
sometimes hear this comment from clients, particularly those
new to doing business internationally. Hedging is simply a
form of risk management, similar to buying insurance. Hedging
involves taking an equal and opposite position in response to
an underlying FX exposure to protect against adverse price
movements. The end result is that a gain incurred by one
position is offset by an equal loss in the other. In a perfect
hedge, all currency risk is taken out of the equation and you
are left with the exact numbers you anticipated at the time of
the commitment. This allows you to focus on your core
business, and trust that your numbers are undiluted by FX
fluctuations. For instance, let’s suppose you agree to sell a
$1,000,000 piece of equipment to a customer for EUR 800,000 at
the exchange rate of 1.25 ($1MM equivalent) with 30 day
payment terms. The moment you enter into this contract you
are now at risk of currency fluctuations, and have entered
into what we call an Embedded Derivative. Although you did
not purchase a derivative in the open market, you have created
risk for the company by the way you structured the
transaction.
Speculation, on the other
hand, involves taking an uncovered position (consciously or
unconsciously) in the market in hopes of achieving a gain.
Many people do not realize that choosing not to hedge a known
FX exposure is the most speculative stance one can take, as
one is subjected to 100% of the market movement between the
times the contract is written and when the currency is
actually exchanged. In the above example, a company that does
nothing has instantly decided to enter the world of currency
speculation.
My company is not exposed to foreign currency
risk because we deal only in US dollars.
Perhaps the best way to illustrate the fallacy behind this is
through a couple of examples:
Suppose you
are selling a product to a customer in France, and decide to
invoice your French client in U.S. dollars, because you feel
that this will eliminate your foreign currency risk. The
dollar then strengthens against the euro by 10 percent over
the next three months before the client is required to pay for
your product. So even though the U.S. dollar price invoiced
to them has not changed, you have effectively raised the price
of your product because dollars are now more expensive in
France. You risk losing customers and sales to a competitor
who bills his French clients in euro, because they are selling
their product for 10 percent less.
Here’s
another example from my experience: a client insisted they
had no FX risk, since they sold everything in U.S. dollars.
One of their markets was Mexico, and they regularly gave their
client in Mexico 3 months to pay for their orders. During
this time, the Mexican peso devalued overnight by about 50
percent. The Mexican company now owed our client TWICE as
many pesos as they did just the day before. So, what did the
Mexican company do? They kept the entire product order, and
did not pay their bill (as they were financially unable to
pay). This caused a huge loss to the U.S. manufacturer, and
their Mexican client went out of business.
FX rates even out over time, so hedging is
unnecessary.
Given an unlimited time frame, this statement may prove true.
Unfortunately, treasury decisions have to govern much shorter
time spans; usually a few months to
1 or 2
years. Take a look at the movement of the euro over the past
10 years:
One could hardly say that the euro has
evened out in this period, nor in any given short-term time
span within it. Assume your company is purchasing product in
euro on a monthly basis. Let’s consider the change in price
of the euro for the 2-year period starting in 2006.
The euro appreciated from 1.2156 in
January of 2006 to 1.4589 at the end of 2007. That’s a 20
percent increase in two years! Just think: how would a twenty
percent increase in your cost of goods sold impact your
company’s financials?
Conclusion
Effective risk management
is about identifying, analyzing, and implementing
procedures to minimize unnecessary
risks
to your core business. It is also about ensuring some level
of financial predictability to future earnings. To this end,
structuring a proper FX hedging strategy can dramatically
improve the bottom line of any company exposed to foreign
currency risk.
GPS Capital Markets
www.gpsfx.com
818-597-9756 |
