How can companies reduce volatility?
Organizations doing business overseas can reduce volatility in their income statements and more accurately forecast cash flows by using tools to hedge their foreign exchange risks. Some people mistakenly associate hedging with speculation and think they’ll be taking on more risk, but hedging limits risks.
How can companies determine which hedging strategy fits their situation?
There are three categories of hedges. The first is forward outright purchase or sale, in which a company locks in a rate today to be used in the future. Money doesn’t change hands until settlement day, and you lock in your profit margin on goods you’re selling. The value of this hedge is the certainty that it provides, i.e., a company will know today what exchange rate will be used in the future.
However, some companies use this hedge and then, if currency rates move in their favor before the transaction settles, they are not happy because they would have come out ahead if they had done nothing. Unfortunately, the company is only looking at one side of the equation, and tends to focus on the change in the exchange rate being a good versus bad decision, rather than the real value of taking an unknown (where the exchange rate will be in the future) and making it known (by locking in a rate today.) In that case, the company has the right idea but has chosen the wrong product. What they want is an option.
With options, you lock in the right, but not the obligation, to sell at a specified price. You pay an up front premium, with the amount dependent on the strike price you choose. You get 100 percent protection from adverse exchange rate movements but dollar-for-dollar gain if the currency moves in your favor.
Yet, some companies do not want to pay a premium up front, so should consider a structured option, where you put two or more options together to reduce or eliminate the premium. You start by buying a regular option, but to reduce that premium, you also sell an option to your FX provider. You earn premium for the option you sell, which reduces or eliminates your cost of the structured option. Then you will be fully protected if the currency moves against you, but you benefit if the currency moves in your favor.
Companies should educate themselves on how to maximize their business opportunities and minimize their risk in foreign exchange markets by identifying exposures and implementing appropriate hedging strategies. <<
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Don Lloyd is senior vice president, Capital Markets, Associated Bank. Reach him at (312) 861-1501 or [email protected].
