To understand the intricacies of foreign exchange (FX) rate fluctuations, take this fictitious example based on real rates: A British shoe retailer buys €10,000 worth of Italian shoes on 22 June 2016 and calculates that it will need £7,603 to cover the order. By 24 June, the day the result of the EU referendum was announced, the sterling amount needed had increased 9.4% to £8,315.
Many small businesses would not be able to bear such dramatic changes in costs and would be wise to lock in the rate for committed exposures straight away, effectively buying insurance against a potential adverse move in the market. The smaller the business, the more sensitive it can be to currency moves.
One reason many businesses hold off from hedging their FX transactions is that they always believe that somehow the rate is going to improve for them. On the other side of the equation, unpredictability and volatility in the currency markets can be seen as an opportunity. When you are watching every penny, there is perhaps more temptation to indulge in speculative behaviour.
This is where a solid FX policy comes in. A defined FX policy tapers back some of the emotions that can drive poor decisions or speculative behaviour and allows the business to focus on core tasks. Emotion aside, a policy provides the business with some structure. A structured approach enables your business to make strategic planning decisions, rather than attempting to respond to day-to-day developments in the market. A well-documented approach to FX can also demonstrate good governance and therefore make your business more appealing to a potential investor or purchaser.
Your organisation needs an FX policy:
- If it exports or imports products or raw materials or services and is therefore subject to transactional risks as described in the example above.
- If it owns assets abroad, such as a hotel or warehouse, or if it has debt denominated in other currencies and is therefore exposed to translational risk that could impact the organisation's financial statements.
Transactional exposures can create translational risks, and vice versa:
- If your company has, for instance, a warehouse full of Italian shoes that it hasn't yet sold, those shoes can be seen as a euro asset.
- Assume you have borrowed in euros to fund a startup business as you expand abroad. If the euro strengthens significantly, how will you find the extra sterling needed to repay the loan?
Steps to creating an FX policy
1. Set out your strategy. The best time to discuss the elements of a policy is when the market is fairly neutral. When everything is calm, you can think clearly. Remember, the strategy is not just for the next three months, it should be evolving and become part of the business on an ongoing basis. The aim of a policy is to give the business enough protection to see it through any movements caused by unknown events (such as natural disasters or terrorism).
If your business has exposures to many currencies, focus on elaborating policies for the biggest risk first. Once those policies are tested and working, drill down and look at the smaller exposures. The CFO should champion the policy as he or she bears the responsibility for this area. Board signoff is absolutely key, as this spreads ownership of the risk to all members of the board.
2. Identify the company's overall FX exposure. Separate parts of your business may well be buying and selling the same currency independently of one another. Look at what is going on all around the organisation, involve the supply chain manager and sales department in these conversations, and centralise the risk. Adopting a holistic approach to currency trading enables you to buy and sell a smaller volume of currency and save on dealing costs.
3. Quantify the risk. Your exposure to risk is measured by two things: the volume of the exposure and the volatility of the currency that you're exposed to. The next step is to calculate your net exposure to the FX market.
For example, if you need to purchase €10 million of currency and you receive €5 million, you have a net exposure to buy €5 million. To calculate the impact this €5 million has on your bottom line, look at the market over the last ten years. The average sterling-euro fluctuation in that period has been around 12% over a year, so the impact of that €5 million on the organisation could be 12%, or €600,000. However, in the most extreme case over that same period, sterling-euro has moved by almost 30%. The average of 12% is the most likely, but the board needs to be aware that in the most extreme case, the impact could reach €1.5 million.
4. Define your objectives. Is the goal, for example, to reduce the volatility of FX risk, or to try to control a certain monetary amount of impact? That objective is the heartbeat of the policy. How much risk the board is willing to tolerate will depend on profit margins.
Where one company might decide to tolerate that 12% on €5 million, another might decide to tolerate €200,000 of risk, and then build a hedging strategy around that. The policy should also set out what tools (such as forward contracts, vanilla options, or FX structured products) the company is prepared to use to mitigate these risks.
5. Assign responsibility. Responsibility for enacting the policy cannot rest solely on the shoulders of the CFO. The policy should state who will run it in the CFO's absence. Look within the finance team. Stipulate who has the authority to trade currency and up to what amount. Ensure that you have established a relationship with an FX broker and have credit lines available for hedging forward.
6. Communicate the policy. For the policy to be effective, finance must work closely with the sales team to ensure they are on top of what the company's exposure is on a day-to-day basis. When large orders are put through, when do they need to be paid? At what rate? If the business has an internal budget rate that sales team members work from, it should be reviewed regularly. If there were to be sudden movements in the FX markets, then you need to ensure that these are accommodated for, either by adjusting your pricing or employing your existing hedges.
7. Review and revise. How often you need to review your policy depends on the nature of the business and the particular business cycle. Companies dealing in perishable goods might look at four to six weeks. Others that have contracted three-year exposures will look over the three-year time frame.
Questions to ask in the review process include: Is the policy doing its job? Does it suit the business? Is it taming the impact of currency volatility that we experienced previously? Are we better off as a result?
When faced with a known event such as an election, referendum, or central bank decision, it's not the job of any business to try to forecast the outcome. Rather, businesses need to understand that the event could give rise to an impact, and ensure that the hedging strategy is robust enough to tolerate any impact.
Chris Towner (email@example.com) is director of corporate at HiFX Europe Limited, which provides international payments and FX hedging solutions to businesses across Europe. To comment on this article or to suggest an idea for another article, contact Samantha White, an FM magazine senior editor, at Samantha.White@aicpa-cima.com.
The most common tools that small businesses can use to manage foreign exchange risk are spot and forward contracts:
- A spot contract is an agreement to buy/sell a specified volume of currency at the current market rate, to be settled within a couple of days, and is used when a business has an immediate need for that currency.
- A forward contract is an obligation. You have a contract agreement to buy or sell the specified volume of currency at a set price in the future. Forward contracts enable a buyer to lock in the price to be paid, or a seller to ensure the price to be received.
Slightly larger businesses with more complex requirements can use FX options and structured products:
- A vanilla option is a contract that gives the holder the right, but not the obligation, to buy or sell an underlying asset at an agreed price, at one or more specified future dates. This comes with a premium payable upfront, akin to a car insurance policy. A vanilla option provides protection against adverse movements in the spot rate below a certain point, while you are able to benefit from any improvements in the rate over the period. There is no obligation, and on expiry you can transact at the spot rate if that is more favourable. There is a premium to pay, calculated as a percentage of the protected notional. The premium depends on the level of protection, the time frame, and the volatility of the market.
- Structured products allow you to buy an FX option to give you protection, but to reduce the cost of that protection to zero premium, you sell an FX option to an option buyer. Structured products include collar options and participators.
Example 1. Some scenarios may call for complete flexibility. Let's say your company is looking to expand into Europe and wants to buy another business for €5 million. You commit to the price, but the deal still has to go through all the regulatory processes and due-diligence checks. As it may yet fall through, you might not need that €5 million after all. In this case, you need 100% flexibility, and the vanilla option works nicely. It provides you with protection if the pound/euro rate falls below a particular rate, whilst allowing you to benefit from any favourable movements in the rate over the specified period.
There are zero-premium FX structures that allow you to have 100% protection against adverse movements in the spot rate beyond a certain point, but at the same time they allow you to benefit from a favourable move.
Example 2. You need to buy $10 million of currency this year to cover forthcoming deals, and that is your only exposure to FX. You are not sure you will need the whole amount but know your absolute minimum dollar requirement is around $6 million.
One option would be to hedge $6 million with a forward. Another would be to hedge the whole $10 million with a 50% participator, which gives you protection for the whole amount, but in a favourable move, you're only obligated to take $5 million at that rate.
If you buy a 50% participating forward, you can participate in 50% of the favourable move of the spot rate. So if your strike/protected rate is $1.26 to the pound, and on expiry of the contract the rate is $1.50, you would be obliged to purchase 50% of the $10 million at $1.26, but you could purchase the other 50% at $1.50, giving you an overall protection rate of $1.38.