Between the effects of a lingering pandemic, ongoing supply chain issues, energy cost concerns and volatility in foreign exchange markets, today’s businesses have a lot to consider – especially when it comes to how to best protect their hard-earned revenue. Foreign exchange (FX) hedging is one strategy that can help businesses reduce their financial risk in the wake of these factors and safeguard their profits.
Kim McKenna, Director of International Services at Rockland Trust, has been working in the FX arena for more than 20 years and is experienced in helping businesses lessen their financial risks by utilizing FX hedging. In this article, she breaks down the basics and shares her top tips for companies to get started.
If you’ve ever traveled internationally, you’re likely already familiar with foreign currency exchange: the trading of currencies between countries. For example, if an American travels to Canada for vacation at today’s FX rate, they’ll find their dollar stretches farther. This same concept is crucial for businesses that make or receive payments in foreign currencies.
For these companies, fluctuating currency exchange rates can have a big impact on their finances. Rates can change based on global economic events, changing interest rates and more. In fact, according to Bloomberg, “The amount of FX transactions has leaped over the past year” due to “currency markets [being] rocked by a medley of influences… ranging from the ongoing war in Ukraine and energy costs and shortages, to interest-rate hikes and Covid-related lockdowns in China.”
So, currency exchange rates are subject to constant change, but what does this have to do with the financial strategy of businesses?
It’s in the best interest of businesses with payables or receivables in foreign currency to ensure that they’re getting the most bang for their buck. The idea behind FX hedging is to lock in favorable rates today to control costs and retain revenue. Locking in favorable currency rates is a smart way to mitigate the financial risks associated with the ups and downs of the FX market.
Real-life example: Consider the case of a luxury travel company that curates customized trips around the world. This company often has to pay local providers in foreign currency, while their customers are typically paying them in U.S. dollars. Because there is a lag between when they are paid in U.S. dollars and when they need to pay in foreign currency, they lock in an FX rate as soon as a trip is booked to protect their profit margin. This way, they are assured their revenue is protected.
While any size business can utilize FX hedges, Kim especially recommends that businesses with foreign currency payables or receivables that are equal to or greater than $500,000 should discuss hedging strategies with their banking partner.
While FX hedging is a strategic and responsible way to keep your profit margins from getting “eaten up” by fluctuations in the market, it’s not a perfect science. Businesses need to decide how much risk they’re willing to take and how much they’re willing to gamble when it comes to currency rates.
In many cases, locking in an exchange rate for a transaction in which you’re paying or receiving in foreign currency will protect your business against undesirable rate movements. However, it’s also possible that costs will get cheaper after you’ve already locked in a rate. Because there’s always going to be an element of uncertainty, some companies that are worried that the grass is greener on the other side can take a middle route by only hedging a portion of their exposure. Other companies might decide not to hedge against foreign currency at all, but are making a commitment to take any losses that occur if rates go south.
Rockland Trust offers two basic types of hedges to business customers: a straight date forward and a window forward. With a straight date forward, customers can set a specific date in the future for a transaction to occur at a fixed FX rate. On the other hand, a window forward hedge designates a three-month window of time for a transaction to occur at a fixed rate. The latter choice is especially useful in today’s world where supply chain issues have complicated cash flow cycles.
Real-life example: A global wholesaler of lobsters source from Canada in the offseason. They often place an order for Canadian lobsters but they don’t pay for them until 60-90 days after they’ve placed their order. They use Rockland Trust’s window forward hedge to lock in an FX rate after they’ve placed their order to assure them the USD cost. The window forward gives them up to 90 days in which they can utilize their forward contract.
Hedging is an important risk management strategy for companies of all sizes to be knowledgeable about. But according to Kim, many businesses, especially those in the mid-market, haven’t had enough training or education on this topic. She notes that it’s critical for today’s CFOs and treasurers to at least have an understanding of the basics. Therefore, a key aspect of her career is counseling businesses on the potential benefits of hedging and the solutions available to them.
One tip she always provides businesses that are just getting started with hedging is to keep a solid record of their decisions. This might look like documenting which transactions you’ve chosen to hedge (or not) in your business plan – and why. Sometimes, this is referred to as a Hedging Policy. This is a useful habit to establish that gives you data to refer to when it comes time to re-evaluate in the future.
Whether you’re responsible for financial risk management for the first time or have been around the block, FX hedging can seem like an intimidating process. That’s why the team at Rockland Trust is here to walk you through your options to protect your business’ revenue and costs, streamline financial planning and cash flow management. To learn more, check out our other resources on the Learning Center or stop by a branch today!
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