Is your business performance partly dependent on exchange rate developments?
When you do business outside the Eurozone, there is a high probability that you face currency risk. You are exposed to currency risk because exchange rates for future receipts or payments in foreign currency are constantly changing. It is therefore unclear how many euros you will receive or pay in the future.
- Hedging currency risk is vital for your business- - Is your business performance partly dependent on exchange rate developments?
- Why hedge currency risk?- Risks for your business
- What happens if you do not hedge the currency risk?- Why have a currency risk policy?
- How does hedging currency risk work?- - Fixed forward contracts
- Flexible forward contracts
- Hedging currency risk leads to certainty- - "NOT hedging currency risk is and always will be speculation"
- ValutaPartners helps businesses
Suppose your company imports a product and pays for it in US dollars. You then sell this product for euros. Every time you import this product, the exchange rate is different. As a result, the amount your company pays in euros also changes each time. Do you have fixed price agreements in dollars and fixed selling prices in euros? Then your gross margin is directly dependent on the exchange rate.
You can prevent this. Hedging this currency risk is straightforward with forward contracts. In a forward contract, you lock in the exchange rate for converting two currencies on a future date: the forward rate. If you hedge your currency risk with forward contracts, your margin is no longer dependent on developments in the currency market. You then no longer speculate, consciously or unconsciously, on whether the value of a foreign currency will rise or fall.
Why hedge currency risk?
Foreign currency trading takes place 5 days a week, 24 hours a day. Exchange rates are established by changes in supply and demand. News, economic data and changes in central bank policy all influence exchange rates. This is a continuous process and the reason why exchange rates change every second.
The currency market has many technical and fundamental analysts. They attempt to forecast exchange rates based on macroeconomic data, expectations regarding central bank policy and charts. However, no one has a crystal ball. No one can predict exactly what the exchange rate will be on a specific date and time in the future. The exchange rate at the moment of conversion is what matters most for your business. Every other rate is irrelevant. Why is that?
Example
Your company will receive $1,000,000 in 3 months and
you do not hedge this risk. You are then consciously or
unconsciously speculating that the US dollar will strengthen
against the euro. In that case, you would receive
more euros for the US dollars sold.
That is a possibility. But a week before your company receives the US dollars, US economic data disappoints, the Fed makes statements about its future interest rate policy AND the US government escalates a trade war with China. The result is a much weaker US dollar against the euro AND EUR/USD rises sharply. Despite your initially correct expectation, your company does not benefit from this. The exchange rate at the moment of conversion is therefore what matters most.
The future exchange rate is thus an important variable affecting the margin on your product or project. Exchange rates are unpredictable. By hedging your currency risk, your business performance is no longer dependent on currency market developments.
Risks for your business
Using forward contracts is often seen as speculation, but the opposite is true. There is often a fear of making the wrong decision, which means you might miss out on a favourable exchange rate movement in the future.
The question you should be asking is not whether it was the right decision in hindsight to hedge or not, but: what risk does the future business performance face if you do not hedge the currency risk?
What happens if you do not hedge the currency risk?
You may assume that exchange rates are volatile enough that the value of a currency sometimes provides an advantage and sometimes a disadvantage. Therefore, hedging currency risk would not be necessary, as it would not matter over a longer period. This CAN work out well for your company's margin when your currency develops in a trend-positive direction. But a currency can also develop in a trend-negative direction. If you do not hedge your currency risk, this leads to uncertainty and can ultimately have significant consequences for your business performance.
Example 1 -- In early May 2020, your company quotes for a project in US dollars. The spot rate at that time is around 1.0800 and the margin on this project is 20%. You decide not to hedge the currency risk. In September 2020, your company receives the agreed amount in US dollars. The spot rate is then 1.1900. That is a rise of almost 10%. The margin on the project has now been reduced to 10%. You expect EUR/USD to fall back to 1.0800 and wait to convert. But EUR/USD rises further to 1.2300, 14% higher than 1.0800. You decide to sell the US dollars. Your company has thereby largely forfeited the margin on the project.
Example 2 -- Your company purchases widgets from a company in China. You buy the widgets for USD 100 each and sell them for EUR 120 each. In June 2021, EUR/USD is at 1.2200. This means the widgets cost EUR 82 each. Your margin is almost 50%. You decide NOT to hedge the currency risk with a flexible forward contract. In the space of a year, EUR/USD falls to 0.9600. This means that 1 widget now costs you EUR 105. Your margin is now only 15%. You now have two options: renegotiate the purchase price with the supplier or increase the selling price.
EUR/USD in 2020
EUR/USD in 2021
Exchange rates can sometimes move against you for months or years and not return to a level that is favourable for your business. If your company does not have the luxury of a long time horizon, it is difficult to wait for this. A currency risk policy prevents this problem.
Why have a currency risk policy?
It is of great importance for your business to have a policy regarding currency risk. This leads to stable business operations. When this is not the case, business performance in euros becomes dependent on future, unpredictable exchange rates.
Suppose your company needs to pay an invoice of $100,000 in 2 months. Do you want to know now how many euros that is, or would you rather wait for the exchange rate in 2 months? This is a choice between certainty and uncertainty. If your company has a policy regarding hedging currency risk, budgeting and determining selling prices becomes simpler. If you hedge your company's currency risk, you always know what the income and expenditure in foreign currency are, expressed in euros. You will then not face surprises after the fact.
How does hedging currency risk work?
If you want stable business operations, you benefit from a stable margin on your products or projects. Locking in the exchange rate for a specific period and a specific amount helps with this. There are two types, namely fixed and flexible forward contracts.
Fixed forward contracts
Hedging currency risk is straightforward with forward contracts. In a forward contract, you lock in the exchange rate for converting two currencies on a future date. This rate is also called the forward rate.
When you enter into a forward contract, you know exactly how much
you will pay in euros for the purchase of foreign currency on the
agreed future date. Or how much you will receive in euros after selling foreign currency. How the exchange rate develops in the intervening period is now irrelevant. The rate has been locked in for that date and for a specific amount.
Flexible forward contracts
Do you receive or pay irregular and varying amounts in foreign currency? Then a flexible forward contract
is ideal.
With a flexible forward contract, you likewise lock in the forward rate for a specific period and a specific amount. With flexible forward contracts, your company also has the option of making interim drawdowns. This is the conversion of part of the total amount at the locked-in forward rate at an earlier point in time. You can do this until the full amount has been used.
Example of a flexible forward contract:
Your company buys an amount of USD 500,000 for a period of 6 months. This at a rate of 1.1500. After 1 month, you want to pay USD 75,000 to your supplier. You instruct a drawdown and convert euros to US dollars at the agreed forward rate of 1.1500. You then pay your supplier USD 75,000. With 5 months remaining, the balance on this flexible forward contract is now USD 425,000. Regardless of what the exchange rate does in the currency market, you always convert at 1.1500.
Hedging currency risk leads to certainty
"NOT hedging currency risk is and always will be speculation"
No one has a crystal ball and can predict the exchange rate for a specific date and time. Therefore, your currency risk policy should be aimed at preventing conscious or unconscious speculation. Hedging currency risk leads to certainty and the safeguarding of your company's margin against exchange rate changes.
For your business, it is of crucial importance to have a policy regarding currency risk. When such a policy is not in place, your business performance in euros becomes dependent on future, unpredictable exchange rates. You can prevent this with a sound policy aimed at hedging currency risk.
Many large companies have a currency risk policy that leads to stable business operations. These companies do not make headlines with disappointing annual results attributable to exchange rates. Every currency exposure is immediately hedged. Is it time for you to implement a currency risk policy?
ValutaPartners helps businesses
ValutaPartners also helps businesses with analysing and quantifying currency risks. A solid currency management policy assists with budgeting and setting selling prices, and leads to business results that are independent of currency market fluctuations.
The experience of co-founder Michiel Souren on both the bank and client side in the City of London provided a wealth of knowledge and expertise. He gained insight into how banks profit from their clients. But also how this can be prevented. In addition, he learned how large multinationals manage currency risk. He wants to share this experience with the Dutch business community. What is unnecessarily complicated, he wants to make simple and accessible. And what is unnecessarily expensive, he wants to make affordable again. These principles led to ValutaPartners.
Co-founder Michiel Souren
Who are we?
ValutaPartners is your online currency partner. We leverage digital technology to connect you directly with the currency market. Our modern technology and efficient operations result in low overheads. We are pleased to pass this cost advantage on to our clients.
