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Currency Volatility: Mitigating Currency Risk due to Exchange Rate Volatility
The value of currency changes every day, this is called currency volatility. When taking part in any business transactions in a currency other than your home currency, your company faces exchange rate volatility. Currency volatility can have a tremendous effect on the cost of doing business internationally. The UK's vote to leave the EU is the most recent example of a major currency event causing significant volatility. Fortunately, there are a variety of currency hedging tactics and solutions that can be employed by your company in order to mitigate risk. This guide will explain the different ways you and your company can hedge currency risk and protect your budget and profitability from currency volatility.
What is Currency Movement: What Influences Exchange Rates?
Exchange rates have a tendency to undergo large, sustained swings away from historic benchmark levels. There are a number of economic factors that influence exchange rates. Even so, the relationship between exchange rates and macroeconomic fundamentals( such as interest rates, inflation, GDP growth or exports) is not a tight one. While movements in macroeconomic fundamentals clearly influence exchange rates, they can do so in different ways during different time periods.
One relationship that does tend to remain consistent over time is that future returns in currency markets tend to move in the opposite direction to the current value of the forward premium (which depends on the difference in interest rates of bonds denominated in each currency).
The currency market seeks to match supply and demand - in general, market participants will prefer to hold those assets offering the highest expected real rate of return. Market participants will base their demand for deposits in different currencies on a comparison of these assets’ expected rates of return.
The interest rates offered by for deposits in different currencies indicate how their values will change over a year. For instance, if USD deposits offer a higher return than EUR deposits, the dollar will appreciate against the euro as investors try to shift their funds into USD.
The rate of return offered by different currencies also will depend on the expected change in the exchange rate. For instance, even if the expected return on deposits in one currency is higher than that on deposits in another market participants may be reluctant to hold deposits in one of the currencies if the payoff to holding them fluctuates too much.
Currency Volatility: An Overview
Volatility comes in many shapes and forms. It broadly captures the dispersion of change of an asset or currency. So, when looking at changes in the value of an exchange rate over time, the volatility would also refer to a change in the exchange rate. For instance, a volatility of 10% would indicate a ±10% change in the exchange rate over a certain period.
Volatility can vary significantly with time from bouts of relative stability to periods of intense violent change. Volatility varies over time for a number of reasons:
News Announcements and Uncertainty: Exchange rates can react violently to news surprises. The arrival of unanticipated news forces market participants to revise their expectations. These revised expectations trigger portfolio rebalancing and high periods of volatility as participants dynamically react to rapidly changing exchange rates.
State of the Economy: An exchange rate functions as an instrument that allow market participants to express beliefs about the state of that currency’s economy. When the state of the economy is uncertain, slight changes in the expectations of market participants may cause large shifts in holding of assets denominated in that currency which in turn feedback into beliefs about the state of the economy. This feedback loop typically generates the greatest volatility when the economy is transitioning between periods of growth and contraction.
Illiquidity/Shocks: During a balance of payments and currency crisis - importers may struggle to access hard currency to pay for imports. During such periods, small changes in FX volumes can cause large changes in exchange rates. This usually happens when unsustainable policies (e.g. a currency peg) are in place. Policymakers are typically are forced to intervene.
Why is it Important to Mitigate Currency Volatility?
Excluding currency hedging strategies from your company’s international business practices reduces your ability to properly facilitate planning and performance management of your business. It is important to understand that everyday fluctuations of currency can affect your company’s budget in big ways. Exchange rates can have a serious effect on profit, particularly if the financial transaction is a large one, meaning a small percentage of change in the exchange rate can have large impact. If the fx risk is not planned and accounted for, you are placing your company budget at risk for either lower profitability or potential losses.
When companies enter international business agreements, either as buyers or sellers, the transfer of funds generally takes place at some point in the future. In relation to currency, this is known as a transactional risk. Transactional risks, fortunately, are the easiest situations to notice and the easiest situations in which to employ currency hedging strategies.
Take, for example, a lumber company based in the United Kingdom. The UK based lumber company enters an agreement with a Finnish company to sell 10,000 cubic meters of birch plywood for 3.0 million EUR, which, at the spot rate, would be 2.32 million GBP.
The UK company is to send the plywood immediately, but will not receive the payment for 3 months. The UK company is now exposing themselves to currency volatility. In 3 months, the exchange rate for GBP to EUR will likely be different. In this situation, should the lumber company choose not to employ any currency hedging strategies, they are placing themselves at risk of a significant change in immediate cash flow.
Mitigating Transactional Risks
Unlike structural risks involving currency, such as the cost of outsourcing to a factory, the fx risk that the UK company is exposing themselves to can be easily managed, and it is important for the financial directors of the company to mitigate the risk through currency hedging strategies whenever they can. If the company chooses not to hedge their risk, they stand to have unnecessary financial losses in this international business transaction.
Assuming the UK lumber company chooses to hedge their currency risk in this situation, how would they do that? There are a variety of solutions available to them.
How Can You Protect Yourself or Your Company From Currency Volatility?
When a company deals with international transactions and decides it would like to begin hedging currency risk, a company might choose to work with their bank. Another option is to engage with an experienced international currency specialist. Currency specialists have never been more available to business owners, and there are a variety of ways to work with them - either via their offline currency team or utilising online platforms.
A currency specialist can help assist your company in hedging currency risk. In the case of the UK lumber company, they can offer a variety of hedging services, these include forward contracts, currency options, futures contracts and limit orders.
Before currency hedging strategies are discussed, it is important to have a basic understanding of the spot rate of a currency. The spot rate, also known as the benchmark rate, the straightforward rate or the outright rate is today’s current rate of a currency. Spot rates change frequently and sometimes change dramatically. The constant fluctuation of a spot rate further reinforces the importance of mitigating risk when dealing in business transactions involving multiple currencies.
What if the UK lumber company chooses to mitigate risk through a forward contract? This would be a commonly used, reliable currency solution for them. A forward contract is a private agreement made between two parties, in which the buyer agrees to purchase a specific amount of currency at a future date at the exchange rate on the date the agreement was entered. In essence, the lumber company would agree to sell 3.0 million EUR in 3 months time at an exchange rate that is fixed now. By entering this agreement, the lumber company now knows the exact value of the payment that will be made in GBP in 3 months. They have now mitigated their currency risk. It is possible that in 3 months time, the exchange rate could change in their favor, leaving them to make less money than they would have. However, one of the benefits of using a forward contract, apart from hedging currency risk, is the ability to facilitate budgetary planning, because now future numbers are known. Without hedging currency risk, planning to this detail would not be possible.
The lumber company could enter an agreement similar to a forward contract, called a futures contract. Like a forward contract, a futures contract is an agreement to buy a specific amount of currency for a specific price at a future date. Futures contracts are traded on regulated exchanges and and have clearing houses that guarantee the transaction. Additionally, futures contracts are renegotiated regularly, and unlike forwards, can have multiple dates, not one specific date. Futures contracts are another way to hedge currency risk, however they are more often used by speculative investors.
The lumber company could also choose to take out a currency option. Another contract, a currency option gives the holder the right to purchase currency at a future time at a specific price. A currency option is another way to mitigate financial risk, however, the fees are generally higher than forwards due to the additionally flexibility they provide. Unlike a forward contract, a currency option is exactly that, an option. The holder of the currency option can choose not to purchase the currency, but they have paid for the right to do so through a broker. This is another strategy, though it is more costly than a forward contract.
The lumber company could also hedge financial risk by placing a limit order. A limit order is an order to buy or sell a currency pair, but the sale only takes place when certain conditions are met in the market. For example, you can enter a limit order to pay for currency slightly above market value at a future date, and this will be honored when the conditions are right. One of the benefits to using a limit order is that it can be canceled at any time, unlike a forward contract.
Real Case Studies: Examples of Business Strategies to Hedge Foreign Exchange Risk
In order to further explain currency volatility and its impact on a business’ day-to-day practices, we spoke about currency volatility with two different companies that do frequent international business.
“There were a few moments around four or five years ago where we were waking up and immediately checking our phones for the new exchange rates.”
Pierre Tremblay, CFO of Dupray
Dupray, is a Montreal-based company. Dupray manufactures and sells a variety of professional grade steam cleaners and irons. Due to the availability of Dupray’s products in multiple countries, their Chief Financial Officer, Pierre Tremblay (pictured), deals with foreign currency risk on a daily basis.
We asked Pierre (pictured above) a few questions about his strategies for hedging foreign exchange risk and dealing with currency volatility as an international business.
FXcompared: Who advises you on your foreign exchange risk strategy?
Pierre: Our advising comes from internal sources. We employ several accountants with advanced macro and microeconomic knowledge and backgrounds, who spend significant amounts of time gathering data and arriving at their own forecasts with regards to currency strategy.
FXcompared: How do you manage your currency risk? Are there products which you use such as currency forwards? How do you decide when to use any of these products?
Pierre: We manage our currency risk through our own internal forecasting models that factor in the volume of currency swaps, the fiat value of our sales and purchases, and the anticipated movement/volatility of the currencies involved. We use only futures contracts, which we find to be less complicated than forwards. We believe futures are lower risk, as the transactions are guaranteed by a clearinghouse. We are generally risk-averse. Whenever we project personal risk, we reduce our exposed position to 50% in order to insure against a miscalculated analysis on our part.
FXcompared: Do you use banks or foreign currency specialists for futures contracts?
Pierre: We primarily use banks. Loyal customers to banks can receive preferential exchange rates when properly aligned with other banking interests.
FXcompared: How do you make decisions as to what currency to invoice a foreign customer in?
Pierre: In our case, we don’t have much choice in the matter. We are obligated to invoice our customers in their local currencies to respect taxation, commerce and currency laws.
FXCompared: What currency hedging strategies do you use for foreign invoicing?
Pierre: Our business does not have a specific hedging strategy for invoicing. Our preference is to view invoicing and purchasing within the same realm and act in harmony.
FXcompared: How does currency fit into your overall strategy?
Pierre: Having our head office in Canada assists us with financial stability. The Canadian currency is (usually, except with $35 oil), a strong currency that is respected and stable from a global perspective. Paired with the fact that the Canadian market is one of our prime selling territories, our expenses are mainly in CAD and EUR, while our revenues mostly arrive in USD, GDP, and EUR. Accordingly, our hedging strategy is more of a “value-added” process to our overall financial strategy.
FXcompared: To what extent can Dupray absorb currency fluctuations?
Pierre: Dupray is able to absorb currency fluctuations because of the variety of currencies which we carry. A downturn in one currency (e.g., currently the Canadian Dollar or CAD) can be easily overcome by the ability of the USD. Being exposed to many currencies is a “natural” hedge.
FXcompared: In that case, where do your main issues derive from in regards to currency?
Pierre: The main issue derives from the non-elasticity of the selling prices when we sell our products to major distributors such as Walmart or Costco. If we purchase our products in EUR and then we sell them in Canada, should the CAD go down substantially (as it has over the last few months), those major corporations will not agree to pay more for their products. Fortunately, the majority of our sales worldwide are generated through our e-commerce platforms, which allows us flexibility should we need to readjust selling prices.
FXcompared: Was there a specific situation, such as dealing with major corporations, where you first realized Dupray needed to start addressing currency risk?
Pierre: We had a couple of instances where our company needed to address currency risk. Obviously, the 2008 financial crash was a big component that really made us aware of the issue. There were many other times, especially when there is a lot of volatility, where we had to sit down and reexamine our position. Traditionally, this came after we bought & manufactured huge quantities of inventory stock, and were stuck selling them to a large distributor at a fixed price. If the currency moves too much, you’re doomed. There were a few moments around four or five years ago where we were waking up and immediately checking our phones for the new exchange rates.
FXcompared: What do you see driving currency volatility as it relates to Dupray?
Pierre: Currency adjustments are done on a macroeconomic scale where Dupray has little say. We would love to have a direct line to Janet Yellen, Mark Carney and Stephen Poloz. Unfortunately, in most countries, that is illegal! At the end of the day, we examine, analyze and shift our financial position to protect our margins and profits.
We next spoke with K.B. Lee (pictured), Founder and CEO of EverBamboo, a company that sells natural deodorizers and dehumidifiers made from bamboo. K.B. Lee uses a different strategy to hedge foreign exchange risk and protect his company from currency volatility.
FXCompared: How do you send or receive international payments and do you use a Currency Specialist for international wire transfers and currency exchange services?
K.B. Lee: We use a Currency Specialist for international wire transfers and currency exchange services.
FXcompared: How did you make your decision to choose a currency specialist? Have you used any other specialists before?
K.B. Lee: We were using the bank service for foreign currency exchange. However, we decided to switch to the currency specialist because it is a local company and they have better rates than the banks.
FXcompared: How do you manage your currency risk?
K.B. Lee: We manage our currency risk mainly by charging both American and International customers in USD.
FXcompared: How does your currency fit into your overall financial strategy? To what extent can EverBamboo absorb currency fluctuations?
K.B. Lee: We sell to distributors in different regions. Sometimes they ask for a small discount because the foreign currency does not favor their price. Companies can’t increase prices because of currency volatility, hence it’s logical to come to us and ask for a price reduction. We deal with this through pricing negotiation. Once the price is set, the price stays the same, unless the effect is significant
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