Foreign currency hedging provides stability, but making a loss is just as likely as a gain
Political uncertainties such as the ongoing Brexit instability, the December general election and the introduction of US tariffs are causing foreign exchange rates to fluctuate.
Currency hedging – locking in an exchange rate to avoid the impact of unexpected peaks or troughs in the market – helps to mitigate the effects, but is not right for every business.
Drapers speaks to the experts to find out when it is the right approach, the risks and benefits, the first steps to take, and possible alternatives.
1. What is hedging?
Currency or FX (foreign exchange) hedging is a method by which businesses can seek to protect themselves against fluctuations in exchange rates when buying and selling across multiple currencies.
Buying currency in advance at a fixed rate to pay for future invoices in a foreign currency, or buying and selling products in the same currency both count as hedging.
It is essentially an extension of what many people do every time they plan a holiday: buying foreign currency ahead of time when there is a strong exchange rate, so they can get the most for their money.
The aim for businesses is to avoid losing money when currencies fluctuate unexpectedly.
“Hedging is used when you operate in multiple currencies from a buying or trading perspective,” explains Paul Martin, head of retail at professional services firm KPMG. “It is used when you want to lock in a rate to give you planning assurances.
“When you’re looking at your operating costs, you don’t want any nasty surprises, such as costs or revenue shortfall that you didn’t anticipate, that are being generated by a mechanism you can’t influence.”
Bobby Lane, accountant and expert adviser to the fashion sector, explains that hedging contracts remove some of this uncertainty: “If, for example, you know you have a bill to pay in three months’ time, you could use a hedging contract to fix the currency exchange rate at the point that you costed your goods. You know exactly what you will have to pay. It can take the risk out of it.”
2. Why would you hedge?
Not all companies hedge. Some do not need to – such as those that do not work with foreign currencies. However, for many businesses, the current political and economic uncertainties are causing increasing instability in foreign currency transactions.
Unpredictable fluctuations of the pound against the dollar and the euro mean that retailers stand to lose or gain more dramatically from currency movements.
For example, in 2016, Sports Direct reported a £15m hit on profits following the collapse of sterling in the wake of the Brexit vote. It said in its report that it had “not hedged” against imports.
“In the past, we would see a linear development of currencies up or down, but at the moment there is a significant rollercoaster,” says KPMG’s Martin. “Before the political uncertainty [from Brexit and multiple general elections] we didn’t see the same kinds of rapid movements as we have seen over the past three years.”
Since August, for example, the pound has ranged from a low of €1.06 to a high of €1.16 – the difference between €10,000 costing £9,434 and £8,621.
“For small businesses, if the currency moves against you,
you could put your whole profit margin at risk,” notes Lane. “If you are a manufacturer and you create a garment to sell to a retailer in dollars, you may have costed that product at a rate of $1.25 [to £1] because that’s where it was when you were doing your calculations.
“If that rate moves against you, you may have to pay 10% or 15% more to make up your difference in costs. Your profit margin could be hit, or, if it’s moved against you that far, you could lose profit entirely.”
Aaron Morley, senior relationship manager for FX company Privalgo, explains that situations such as this have caused alarm for some retailers, and have made hedging an increasingly important consideration: “A lot of companies have never hedged [because theywere set up in times of FX stability], but, as sterling has been fluctuating so much, they are beginning to see the value.
“For a lot of the young digital brands, from the time of their inception the sterling has always been a strong currency. Companies like Boohoo and PrettyLittleThing, which have grown quickly in a relatively short time span, were started after the financial crisis, when sterling was a strong and stable currency. Since the financial crisis in 2008, there has never been a better time in business to see the benefits of hedging and the risks of not hedging.”
3. How can you hedge?
People typically think of hedging as contracts that fix exchange rates for a period of time. These are known as derivatives, and typically are arranged by FX providers and banks.
However, there are other ways of protecting against currency movements that do not involve entering these agreements.
Robert Waddington, director of treasury advisory and assurance at PWC, explains that before considering derivatives, businesses should investigate whether they have any “natural” hedges: “If you have sales in euros and purchases in euros, you have a natural hedge.”
Natural hedges mean that there is no FX exchange risk in the transaction itself – the only time an exchange loss or gain is made is when the final profit is converted into sterling.
Lane explains: “If you buy from your suppliers in dollars and also sell to customers in dollars, you have no exchange risk in the transaction itself. You may buy something for $10 and sell to customers for $15. Then your $5 profit is then sitting in a $ bank account. The only time you have an exchange gain or loss is when you convert to pounds.”
Waddington adds that businesses may be able to find areas to which they can pass the impact of FX movements: “If I have euro purchases, and flexibility in my sales price, I can pass on euro movements [by increasing] my sales price.”
If you do not have any natural hedges, derivatives that fix exchange rates for a period of time could be an option. These are contracts entered into with FX providers.
“Those can be the big corporate banks, but there are also mid-size online hedging businesses,” explains KPMG’s Martin. “They take a cut of the exchange rate and they will also request a management fee, because they are essentially carrying the risk in that context.”
Waddington stresses that derivative hedging should be the last option for smaller retailers, as it carries greater risks: “You can either gain or lose. People forget that the aim is certainty, not to make a gain.”
For smaller businesses, derivatives may not be an option, Waddington adds: “Not all companies have credit lines to be able to enter into them. Often, bigger retailers will arrange them with banks, and not all companies have access to this option. There are some smaller ‘non-bank’ [FX providers] that offer them, but it’s not a definite you’re going to get them.”
He continues: “Even if you do enter into them, you have to make sure they are with a counter party you are willing to do business with. It’s not just a case of being offered something and agreeing to it. You have to think about whether they are a reputable third party.”
4. What are the benefits and risks?
The central aim of hedging is certainty. It provides guarantees over financial commitments: knowing exactly what you will pay and how much things will cost.
Privalgo’s Morley says key benefits include protection from adverse currency market movements; easier forecasting; improved customer relations because of consistency in pricing; and the ability to retain profit margins that were budgeted against a set FX rate.
However, fixing an FX rate 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 Morley. “And if you are protected at a worse rate than the prevailing market rate, your products could end up costing more than your competitors’.”
Lane says, “The whole area is about how you de-risk your business and your transactions. You have to look at what the potential risks are of the transaction, and what the risks are to the business, and ask: if the FX moves against me, am I comfortable with that loss?
“If you’re not comfortable with it, then hedging takes the risk out of that transaction.”
He also notes that hedging contracts often have associated costs and charges from the companies running them, as they are acting as an “insurance policy” for those working with them. Morley adds that businesses must have a strong cashflow to support the costs of hedging.
KPMG’s Martin cautions that hedging can be a “double-edged sword”, especially in the current political climate: “If you want to have security and not have bad surprises, then hedging is generally advisable, but exchange rates are moving at a pace that we have never seen before.”
5. What are the first steps?
Not every business will want to hedge, so start by analysing what the risks and benefits are, and how they will affect your business plan and cashflow in the long run.
To do this, businesses must have a clear view of their financial situation and future commitments, says finance expert Lane: “The first step for any business has to be to put a forecast together for at least the next 12 months. It should have a profit-and-loss forecast and a forward cashflow forecast. If a business has an idea of what it needs, then it can look at how to deal with and mitigate those risks over time.”
“If you know that your buys are in certain seasons, for example: you buy in August/September so that’s when you’ll need to be paying your bills – you need to be forward forecasting to make sure you have that cash there and you know what hurdles will surround that.”
“Understanding what your exposures are is the first step before hedging,” adds PWC’s Waddington. “This involves making sure you understand where you’re buying things from, what currency you’re buying that in, and where you are selling, as well as what flexibility you have to adjust the sales price to pass on FX fluctuations.
“Once you understand the exposures, there are mechanisms that can protect you from FX without going into the derivatives.”
He notes that the second step must be deciding how much risk the business is willing to take on, and whether it is prepared to lose out if rates change: “It’s also important to have clear objectives of what the goals of hedging are.”
He emphasises again that hedging can be a risky business, and losses on the exchange are as common as gains.
The essential questions before hedging
For Privalgo’s Morley, there are five key questions people looking to hedge should consider:
- What do you hope to achieve from an FX hedging strategy?
- What impact would a 10% move in the FX market have on the business?
- How easily and quickly can you re-adjust pricing with customers or suppliers?
- Can you accurately forecast business currency requirements?
- Do you have cashflow that can support currency hedging requirements?