Before we dive into the strategies to hedge your foreign exchange risk, do you know what is a foreign exchange (FX) exposure? If you don't, check our video below:
How to assess your FX exposure?
Before implementing a hedging policy, a company must assess its FX and or exchange rate exposure on the market so it has a clear picture of its exposure and can better assess how to manage it. When a company transacts in a currency other than its domestic currency, it enters a market position.
Example: For example, the Hong Kong-incorporated company below, whose domestic currency is HKD, is in a market position because it transacts in EUR and GBP.
The table shows an example of FX flows dealt by the company:
Based on the data above, the company can assess its unrealised gains or losses as follows:
The example above highlights that the company has FX exposure, which can be reduced or eliminated.
See ‘Which hedging strategy…’ below for ways to manage exposure.
It is critical for a financial officer to assess in real time the company’s open FX positions to better manage them.
Which hedging strategy is suitable for which type of company?
1. No hedging strategy
If a company decides not to hedge, it will be fully exposed to foreign currency fluctuations until the invoice is settled. As a result, the company will record an exchange rate gain or loss in its accounts.
The person in charge of the hedging strategy at the company surely expects some FX gain, but this is a risky approach for a company, and it could ultimately negatively damage its relationships with shareholders and banks.
In rare cases where companies have adopted this strategy, the main reasons were lack of access to hedging tools, or the company having a global policy not adapted to local markets.
2. Partial hedging strategy
A company may decide to implement rules to reduce its FX exposure on, for example:
- Sales and purchases (e.g. hedge a certain percentage of the total sales or purchases volume).
- Exposure at the end of each day, week or month (e.g. hedge a volatile currency based on its weight on overall sales volume).
- Net exposure at a certain exchange rate range (e.g. hedge a certain percentage of the total sales volume when the exchange rate falls within a certain range [‘limit order’ or ‘stop order’]).
Partial hedging strategies are usually implemented by companies that do not wish to take a systematic hedging approach.
3. Systematic hedging strategy
If a company adopts a systematic hedging strategy, it will have almost no FX exposure. Given that the FX market is extremely volatile, with rates changing within short periods of time, it is impossible to have no FX exposure. The flip side of systematic hedging is the opportunity loss if the exchange rate changes favourably during the hedging period.
This strategy is rarely adopted by SMEs because financial institutions do not offer such services for SMEs. However, if a business knows its payment flows, it is recommended to adopt a systematic hedging strategy. If a business can only estimate its payment flows, it will be more challenging because it would not know if the amount hedged is too much or not enough.