Currency Hedging in Times of Extreme Volatility

Since the 2008 financial crisis FX markets have enjoyed, on the whole, a decade of relative stability. This is particularly true over the last couple of years, with volatility reaching an all-time low as recently as January 2020. Sure, the Swiss central bank rocked the currency markets back in 2015 when it removed the swiss franc’s peg to the euro and the pound saw huge drops after its 2016 brexit referendum (in which the value of sterling slumped to a 31-year low on currency markets) but these were both individual shock events.

Since these major shocks, FX market volatility had been dwindling. That was until COVID-19 wreaked havoc for economies and financial markets around the world, where due to these unimaginable and unforeseen circumstances, we’ve already started to see a much more volatile 2020 vs 2019. In this article, we don’t focus so much on explaining the various hedging instruments – such as forward contracts, limit orders and swaps – as we explain this elsewhere. Rather, we prefer to look at the fundamental hedging principles and hedging strategies that can be particularly important when currency markets are volatile.

Now the world is facing a new type of threat.

According to Denis Golomedov, CMO at RoboForex, coronavirus will keep traders on edge for quite some time “The markets were affected by the coronavirus, and we must admit that the story is not over: it will require at least six months for countries to take it under control. Six months later, the influence of the virus on the economy will also become obvious, and it will not be pleasing,” Golomedov continued “So, market circumstances cannot be called comfortable at all. If global economies, indeed, reflect the decrease in GDP and other key macroeconomic parameters (which is really probable), the indices and assets will slump into a long downtrend. The volatility here will be more of a foe than a friend.” 

Hedging, defined as using a strategy to offset the risk of market movements, may not always be the correct course of action to manage your overseas exposure but in most cases hedging can help you strike the right balance between risk and reward. If you hedge all of your currency exposure it means you could miss out on the positive impact of exchange rate moves in your favour but by not hedging at all you could lose out if the market moves against you. With many economists and market analysts in agreement that currency volatility will be higher throughout 2020, building the correct hedging strategy will be an important step for businesses who are heavily exposed to currency markets.

The Four Pillars of a Successful Hedging Strategy

Whilst one company’s hedging strategy will look different to the next, it is important to review the three key pillars (as outlined by Currencies Direct) to determine the most appropriate solution for you.

Identify: Before taking any action, it’s imperative to identify the extent of your company’s exposure to currency market movements. How many positions do you currently hold in the currency market? How frequently do you need to make international payments, are they regular and what size are they? Do you have to occasionally make larger payments?

By beginning to understand how much exposure you will have throughout 2020 you can then establish the potential impact of exchange rate shifts on your cash flow and define your objectives. How much risk are you looking to mitigate and at what cost?

Strategy: Once you’ve identified your objectives, you can then discuss your business requirements with international money transfer and currency specialists. Talking through the various options will help you ascertain how much of your currency exposure you want to hedge and the most appropriate FX products to achieve this. These tools should ultimately help to protect your profit. Consultations are free and there are certainly no obligations to go on and trade with a particular currency specialist. 

Review: Once you’ve implemented your strategy it should be monitored closely and reassessed on a periodic basis to make sure it’s performing optimally.

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Hedging Strategies for Consideration

Natural Hedges

The most obvious approach is to take advantage of any “natural hedges” that occur within your business. For example, when you generate revenues in a foreign currency it can also be used to pay for costs incurred in the same currency. If the majority of your sales are in USD then you may look to seek financing in USD too. Natural offsets of this sort provide a measure of protection. 

Similarly, if you have a heavy reliance on two currencies it may prove beneficial to keep an equal value of each currency. For example, if your company is exposed to GBP and USD, it can offset any GBP depreciation with gains by USD and vice versa. 

Natural hedges used on their own do have their limitations and will not provide total protection against currency risk.

Rolling Hedges 

Companies with ongoing exposure to exchange rate volatility may use forwards, swaps or options contracts to hedge against currency swings. A rolling hedge will help to mitigate risk by closing a soon-to-expire hedging product (such as a forward or option contract) and simultaneously opening a new contract, pushing back the maturity date of the initial hedging product.

CFO Brian Yoor of the US healthcare giant Abbot implemented a successful 18-month rolling hedge strategy. “ We went through to see where hedges were available in certaincountries and whether they were affordable… we were able to use a blend of certain instruments that generated income for us in a very volatile environment.” Depending on how rates have moved in your currency pair through the duration of your hedging contract it may prove more expensive to renew your existing hedges but Yoor continued “You’re still realizing a benefit, but it’s not as much year-on-year,”

Dynamic Hedging/Pricing

Dynamic hedging has traditionally been used as a hedging tool for overseas investment portfolios. Mitigating the risk of currency movements to ensure your assets remain a true reflection of their underlying value. Nowadays, technology companies are utilising a similar concept for businesses who sell internationally.

Businesses who sell goods or services overseas with prices in a foreign currency face continuous exposure to fluctuations in exchange rates of those currencies. There are three options the company has:

  1. Make no hedges. Simply use the exchange rate available on the day you are looking to repatriate your overseas earnings. Doing nothing is certainly not an active strategy, but taking the rough with the smooth day-by-day is still very much a currency strategy.
  2. Pre-Hedge. A company sets their product prices in a foreign currency, which should be based on a target exchange rate. Companies can then hedge their estimated sales volume for a defined period, such as a month or year, in advance. This strategy can allow steady and guaranteed margins for the duration of their hedging tool, but it provides less flexibility to actively respond to market conditions, such as seasonal sales.
  3. Dynamic Hedging. A company sets prices based on the daily exchange rate and then hedges accumulated sales at the end of the day or when certain agreed volumes are hit. The company has then hedged all their exposure at the current exchange rate (and with a minimal differential with their target rate). The company can opt to keep prices the same if exchange rates remain constant or change pricing to preserve their profit margins when exchange rates move.

Balance Sheet Hedging

Only available with international money transfer firms who hold a separately regulated subsidiary for options business such as Global Reach Group. Balance sheet hedging is a corporate treasury tool used by businesses to reduce the potential impact of exchange rate fluctuations on their balance sheet. 

Successful balance sheet hedging requires firms to measure the impact of FX rates on monetary assets outside of their primary reporting currency, forecasting these assets in advance so they can be hedged (including impacts on the asset from depreciation) and ensuring that liquidity provision (whether in local currency or functional currency as required) does not adversely affect the balance sheet. 

Final Word on Hedging in Times of Increased Volatility

As Robert Royall, Derivatives and Financial Instruments Solution Leader at Ernst and Young puts it, “The issue is volatility, not what the long-term trend is. Hedging doesn’t reverse the long-term trend; it helps to smooth the jolts along the way. You have to decide if hedging is something you believe in or not.”

Some companies will prefer to remove as much risk as possible, others will take the view that currency swings are part and parcel of being an international company and currency swings tend to even out in the long run. However, the latter isn’t entirely true and companies have a variety of tools available to help them manage currency risk. It’s impossible to escape the effects of volatile exchange rates entirely but the key will be to return to the pillars of a successful hedging strategy – continuing to reass whether you have the best mix of hedges to address your particular currency exposure at this particular time, and redoubling your efforts when volatility is high.