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Wednesday, November 26th, 2008 Comments Off on Currency Hedging as a form of Business Investment

With the combination of unprecedented volatility in foreign exchange markets, and an economic slowdown set to impact importers and exporters alike, foreign exchange management is now becoming an important element of business practice.

For many, currency hedging has been regarded as a speculative exercise, often an afterthought that has little positive impact on their business.  At its best, however, currency hedging can be an important investment in a business’ global growth, and for the astute business owner, the current volatile environment will cement their ongoing success.

Like any investment process, the key to success is to implement a set of principles and our model adopts three:

1.       thoroughly understand the short, medium and long term business goals

2.       deliberately protect each company against serious foreign exchange losses

3.       aspire to “adequate”, not extra-ordinary, performance of the currency hedging programme

To successfully hedge foreign exchange exposures does not require remarkable business acumen, unusual business insight or a crystal ball.  What it does require, is a sound framework and the ability to apply this framework with a sense of discipline so that emotions are kept from corroding that framework.  This is what Warren Buffet describes as “emotional discipline” and while he applied to it stock investing, it is equally appropriate to foreign exchange hedging.

Having an understanding of the pricing points and costing levels and the subsequent exchange rate that this implies, is an important first step.  From this it is possible to protect against serious foreign exchange (and profitability) losses through the use of fixed rate hedging contracts over the short and medium term.  The accumulation of small consistently sized positions allows the opportunity to take advantage of favourable exchange rate movements while ensuring that any hedging undertaken at rates below those costing levels will have limited impact.  This is a variation on the value investing approach of “dollar cost averaging” and is designed to smooth hedge portfolios using an averaging approach.

Perhaps the greatest temptation when executing a currency hedge programme is to rely on experts’ forecasts.  As recently as July, consensus view held that the Australian Dollar would be trading at parity by Christmas.  As is often the case, this has not occurred.  Many importers, having held off on their currency purchases, are now feeling the brunt of a 40% decline in the exchange rate.

Exporters have also been impacted.  Many took large positions as the exchange rate began to fall and now have significant hedging that is not allowing them to take advantage of the prevailing favourable exchange rates.  This is arguably an opportunity cost, rather than a physical loss as exporters that have been able to lock in exchange rates below their costing levels have ensured an “adequate” return on their hedge portfolio.

This raises another risk, particularly for exporters.  In the current environment, it can be tempting to want to “lock in” foreign exchange rates over longer time frames (3 -5 years) using fixed rate hedges, but we would counsel against this idea.  The reason is that business conditions change over longer term time horizons as do financial conditions.  The last three months is a case in point.

Instead, these long term horizons provide an opportunity to ensure protection as well as adaptability through the use of flexible hedging tools.  This is the third principle and it ensures that over the long term, business operations are not beholden to hedging arrangements that might have been suitable 12 months ago but do not apply in today’s market.

For exporters, now is an excellent time to consider long term foreign exchange hedge programmes.  The combination of high levels of volatility and exchange rates not seen since the beginning of the decade provide tremendous conditions to manage their long term foreign exchange requirements.  Our preferred approach over these time horizons is to apply products that use volatile market conditions to clients’ advantage.  In this regard we suggest “insurance type” structures that will ensure that the risk of serious foreign exchange losses are mitigated but will also allow companies to take advantage of improved foreign exchange markets should they exist 3 or 5 years in the future.

For importers, this is a time to look at the short and medium term environment, ensuring that costing levels are protected from the wildly volatile and changeable conditions.  While each client will operate under different parameters, there will still be scope to consider longer time horizons, but this is more appropriate when exchange rates are some 5 -7c above your costing levels.  At this time, it becomes opportune to ensure that there is the potential for participation in favourable exchange rate movements while ensuring the protection of the overall business.

It is important to remember, that for businesses operating internationally, an ability to ensure consistent pricing in volatile times can provide a competitive advantage.  Picking the top or the bottom of an exchange rate cycle is lucky.  Ensuring that your currency conversions are undertaken at rates better than your budgeted exchange rates will provide a potential buffer during difficult trading conditions.

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