These are unprecedented times, to say the least. There are ongoing market uncertainty and volatility due to global factors such as the second wave of the pandemic and global companies facing trade and policy-related post-election risks. As financial leaders, you know the importance of safeguarding against these disruptions that continue to plague the global economy and your business. Risks associated with foreign currency exposure such as daily changes in not just the greenback but other currencies such as RMB and Euro which all have repercussions that have a direct impact on companies’ bottom lines. In our US election guide to US dollar volatility, we discussed the various ways you can protect your company’s financial health by implementing foreign exchange risk management strategies that help mitigate the impact of the unpredictable foreign exchange market. Now more than ever, you’ll need to implement these strategies to protect your business. Here’s a recap on what three strategies you need to consider now:
Hedging with foreign exchange is by far the most important strategy to protect your business from currency fluctuations. In a global business, exposure to a secondary currency is fairly run of the mill. By hedging, you can protect an exchange rate in a chosen period so any exchange rate movements will not affect your costs of goods, payments you need to make, or your pricing structure. This provides your company a measure of certainty against future cash flows, and profit forecasts. Here are three tried and tested ways you can take advantage of hedging.
With a forward contract, your company can acquire a customizable contract that obligates your company to buy or sell a specified currency at a specific price and future date. One of the most commonly employed methods of hedging, forward contracts are best used with cash flows that are certain.
The Benefit: By allowing your organization to lock in a fixed rate of exchange for the purchase or sale of a foreign currency at a later date, your business is given the flexibility and the tool to hedge against swings in the currency markets which eliminates downside risk exposure. Fixing the rate means that you can develop a clear budget and guarantee costs.
Options give you the ability or the right to buy or sell a pre-agreed upon exchange rate of a specific currency on or before an expiration date. For this right (not an obligation) there is a premium to be paid. FX options are often used to hedge against uncertain foreign currency cash flows. Options trading can be complex as there are different types available such as vanilla and spot options.
The Benefit: Options are available even for small amounts in all major currencies and can be taken out at any time. Companies have unlimited upside potential with limited downside risk. As an option buyer, you know the maximum cost at the outset as you are required to pay the premium and the funding cost upfront. The only loss is the premium paid.
A swap is a multi-legged agreement between two counterparties to exchange financial instruments, cash flows, or payments at multiple intervals. The simplest swap format is used to roll a forward to a later date. It consists of a spot transaction linked to a forward. More complex swaps (their structure is derived from interest rate swaps) manage multiple periodic future flows and are most commonly used to manage foreign currency debt.
The Benefit: Reduces the cost of borrowing as you are taking advantage of a lower rate of interest.
With these three options for hedging, financial officers can arm themselves with the knowledge necessary to take the right steps in foreign exchange risk management. However, hedging comes with risks and every company has different needs, capabilities, and requirements. Talking to a moneycorp risk specialist will give you a better sense of which strategies you should be implementing now with tailor-made solutions that are designed to achieve your goals and maximize profitability. For more risk strategies, listen to our podcast on Hedging Amidst COVID 19 Market Turmoil or contact a moneycorp specialist.