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Guide to Growth: Currency hedging – what you need to know

Currency or foreign exchange (FX) hedging is a financial tool that businesses can use to help protect against the negative impacts of exchange rate fluctuations if they buy or sell in multiple currencies.

Typically, hedging is used by large businesses and retailers, but smaller businesses could also stand to benefit. Any business that conducts substantial transactions across different currencies should pay attention to hedging.

With the continuing political and economic uncertainty in the UK, foreign exchange rates are more volatile than ever before. Unexpected swings in exchange rates can mean businesses end up having to pay more than they anticipated for goods if they had forecast the payment at a more favourable exchange rate.

Hedging can involve “fixing” exchange rates in advance of payments, using contracts called derivatives that are typically entered into with banks. Alternatively, businesses can use “natural hedges”: buying and selling products in the same currency or finding areas where negative currency fluctuations can be absorbed or passed on.

Robert Waddington, director of treasury advisory and assurance at PWC, says that for small businesses, understanding the potential impacts of currency changes and exploring potential “natural” hedges should be a priority.

“Understanding exposures [to currency headwinds] is the first step,” he explains. “That’s making sure you understand where you’re buying from and where you are selling. Once you understand the exposures you can identify if there are mechanisms [such as natural hedging] that can protect you from foreign exchange changes.”

If the aforementioned elements are not suitable for your business, derivatives are another option, but there are several things to carefully consider before investigating, as they can be complex, expensive and risky.

Crucially, businesses need to understand that derivative hedging is a tool to “de-risk” transactions, not a tool to drive financial reward.

“You can either gain or lose. The purpose is certainty, not to make more money,” explains Waddington.

“Hedging should be used to make sure your company is not at a competitive disadvantage,” adds one former retail industry treasurer. He notes that businesses must be fully aware of the risks of hedging before they enter into derivative contracts.

While fixing exchange rates is beneficial if currencies move negatively, it could also lead to a business losing out if the currencies it is trading in move in a more favourable direction.

“Fixing the price can be a disadvantage if the exchange rate improves,” says Aaron Morley, senior relationship manager for FX company Privalgo. “And if you are protected at a worse rate than the prevailing market rate, your products could end up costing more than your competitors’.”

If you think hedging is something that could benefit your business, first: pinpoint your financial situation and possible exposures and consider how a 10% currency move would impact you. Next, consider if there are “natural” hedges in the business, or whether prices can be readjusted to absorb impact.

Morley also advises considering your goals with a foreign exchange hedging strategy and whether your business has the cashflow necessary to support the cash outlay and costs associated with derivative hedging.

Although it has its benefits, hedging is complex and not without risk. Seeking independent advice from financial experts – rather than directly approaching dealers of derivatives – is advisable for those businesses seeking to integrate hedging into their strategies.

Our new advice portal for retailers and brands, Guide to Growth, aims to solve the problems and challenges fashion businesses encounter as they grow. Email your questions to associate editor graeme.moran@emap.com and we will get them answered. 

Plus, read our Growth in a Changing Economy report here to learn how fast-growth brands and retailers are overcoming barriers to growth. 

Drapers’ Guide to Growth programme is produced in partnership with Clipper.

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