If your business is exposed to foreign exchange, whether through foreign currency sales or from overseas purchases, foreign exchange volatility can be unsettling. Depending on which side of the exchange rate your business is exposed to, currency movements will be felt differently:
- a stronger domestic currency benefits importers by reducing costs of overseas purchases in domestic currency terms
- a weaker domestic currency benefits exporters by converting overseas sales into higher domestic revenue
As an importer, in a weakening currency environment, there is a fear that the currency continues to weaken so you may feel inclined to transact hedging now. However, the greedy side wants to wait for the currency to bounce and present better opportunities. And vice versa for an exporter.
FX risk management policy limits emotion
A foreign exchange risk management policy has risk control limits designed to take some of the emotion out of decision making and acquiesce the temptations to make knee-jerk, significant decisions. Trying to predict the direction of foreign exchange rates is a fraught business and the best analysts in the world will be lucky to get it right 50% of the time. You just need to look at the various bank forecasts to understand the difficulty. No one crystal ball is better than another. The chart below shows the diversity of min, max and median across 20 forecasters of the GBP/USD exchange rate over the next 12 months.
A policy is often a formal, board approved document that contains minimum and maximum risk control limits across time periods. Depending on the nature of your business, factors such as the ability to pass through impacts of FX movements to customers will influence the time horizons and min/max limits. However, the general rationale is that you have higher percentage of hedging in the near term when sales/costs are known/more certain and lower levels of hedging for longer terms due to the greater cashflow uncertainty. This is a “layered” approach to FX hedging.
Generally, the management team has discretion to maintain hedging levels within the board approved minimum and maximum risk control limits. The policy is intended to smooth out the peaks and troughs of currency cycles, reducing volatility. A layered approach to hedging encourages many small decisions to be made regularly often in conjunction with the market expertise of your bank/broker/treasury advisor. Adhering to policy risk control limits (which have been pre-determined using robust analysis) gives a framework to operate within when the markets are volatile and emotions are running hot. A policy that has forced a minimum level of hedging will buy the company some time before having to adjust prices in-line with the prevailing market.
Hedging should be proactive, not reactive
Visibility of the hedging position that can be reported to senior management in clear and simple terms demonstrates a disciplined approach to managing foreign exchange risk. Hedging should be proactive rather than reactive and avoid making impulsive (and likely regretful) decisions. A foreign exchange risk management policy provides the confidence of hedging within a structured environment of control and compliance which can be particularly comforting during times of volatility.
Hedgebook helps with keeping track of compliance with your foreign exchange risk management policy, as well as helping formulate one for those contemplating going down this path.