The Why, How and What of Hedging Currency Risk
by Simon Bishop, Director and Head of Corpay Singapore
Simon Bishop, Director and Head of Corpay Singapore, has more than twenty-five years’ experience in foreign exchange trading and risk management, in addition to seven years as a business owner. His experience spans both the buying and selling sides of the market, and in his career, he has seen the good, the bad and the ugly.
Simon came to Singapore in 2022 to head up Corpay’s FX and risk management practice. Under his watch the Singapore business has expanded from a team of seven employees to a team of twenty-one.
In speaking to clients about their hedging journey, Simon conceived of the three-part series, The WHY, the HOW and the WHAT of Hedging, to help clients develop and/or implement their strategy that serves their business needs and helps demystify currency hedging.
Introduction
In my experience, everybody begins with the WHAT: the currency hedging product. But the product is the end result, not the beginning. You need to understand the WHY and the HOW before you get to the WHAT.
The foundation is WHY: why you might choose to hedge currency risk, and why you might not.
Next comes the HOW: how to evaluate your business needs and goals, and how you develop a risk profile and hedging strategy that suits your business, and how to implement it and review it.
This particular journey ends at the WHAT: an introduction to different currency hedging products and their function and potential outcomes.
Part of our job is to educate you on the benefits and the potential advantages of doing one thing versus the other: but ultimately, it’s your decision to hedge or not to hedge.
It’s not as complex as it sounds. Your business will tell you what you should be doing.
As a business owner involved in import or export or both, your focus is more likely to be generating more sales, not worrying about where the USD/SGD is going or where EUR/USD is going.
To hedge…
To break it down simply, if you go down the ‘to hedge’ path, what do you get? You get certainty of gross margin and cashflows. You get reduction of volatility of income and you get ease of planning.
If you decide not to hedge, you might have an outcome that outperforms compared to if you had hedged. However, what you will get is uncertainty of gross margin and cashflow, and a potential increase in volatility of your income, which may make it more difficult to plan. If you don't know what your cashflow is going to look like over the next six months or you don't know how much profit you're going to have, it becomes very difficult to plan for the future.
Many businesses have fixed costs, such as overhead, and variable costs, such as sales revenue and the cost of goods sold. An adverse move in the currency—in your cost of goods or your sales revenues—can affect your gross profit margin adversely.
In this scenario, you may consider hedging to reduce income statement volatility and volatility of local earnings. It's as simple as that. If you want certainty, embracing the currency hedging path could be a good option. Another reason why you might hedge is to help protect cashflows which could help ensure your profitability stays consistent and predictable, and likewise, your cashflow.
Or not to hedge
There are a few circumstances where hedging might not be appropriate for you. Firstly, if you’re not 100% committed to creating and implementing your currency hedging strategy, you might not wish to hedge as there is a chance you will be unhappy with the outcomes. Secondly, speculative hedging is not supported by Corpay. Thirdly, if you have no FX risk due to the way you price your products/services, why would you create risk by hedging?
Lastly, if you don’t fully understand the product you’re using and the potential outcomes, don’t proceed: get more information and seek professional advice.
The WHY of Hedging:
Why you might or might not hedge depends on your business
Next, we address the HOW: building your strategy, implementing it. And reviewing and monitoring it.
A good strategy can remove a lot of the uncertainty about whether or not you should be hedging.
No strategy is perfect, but the key is to have one to begin with. You can always work on improving it, which, in my opinion, is a lot better than having no strategy at all.
Here are some important considerations that will help you develop and implement your strategy:
Pricing.
Pricing is not an accounting item but a component of your business. Consider how you price your product, for how long your prices are fixed, and how often you can change your pricing.
Your risk profile.
Everybody's risk profile is different. Are you comfortable taking on some of the currency risk, warehousing some of the risk, yourself?
Your budgeted rate.
What is the rate you need to achieve on your FX in order to protect your margins? And is that rate achievable?
Your financial position.
If you are in a good financial position, you might decide to hedge a portion of your requirement.
Your competition.
In a highly competitive business sector, currency hedging might be a challenge.
Execution.
Can you execute the plan that you have in place and the strategy you have in place? Do you understand the products you are using and the possible outcomes? And are you able to stay the course? At times you may be tempted to change your strategy because of a view on the market.
Each business is different, with a different risk appetite.
It's not what a competitor or a vendor might do, or based on the opinion of someone unrelated to your business. It’s your business and your strategy. Your business will tell you what you ought to be doing.
The HOW of Hedging:
How you build your strategy, implement it and monitor it
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The primary reasons why most people balance-sheet hedge are to protect gross margin and create cashflow certainty.
Your product selection, aligned to your currency hedging profile and risk appetite, will help you achieve those goals.
A wide array of products exists, and they produce different outcomes. They can be blended depending on your exposures and your goals.
We’ll explain the function of the main hedging structures here, starting with the forward exchange contract and moving to FX options and FX structured products. We cover them in greater depth in the WHAT discussion.
Forward exchange contracts: locking in a future rate
The forward exchange contract is the most basic hedging structure. It is effectively an agreement between the customer and Corpay to exchange a specific amount of currency at a future date at a predetermined rate. That rate is determined by the current spot rate and the interest rate differential between the two currencies.
Bear in mind that the rate is locked in, no matter where the market is on the date of settlement. If the market moves in your favour, you won’t be able to take advantage of it. But if the market moves against you, you are fully protected.
This product is really good in helping to create certainty, and is probably the most common hedging structure.
FX Options and FX structured products
There are three basic types of currency options: a protection option; a participation option, and an enhancement option. Each has different advantages and disadvantages, but the one you choose will be related to your business and your risk profile.
If you’re very conservative, or your business cannot afford a market move against you, you may consider protection and / or participation.
But if you're in a more complex business, and you understand the products and have the ability to absorb additional risk or deal with the unexpected, you might look at enhancement products.
With structured products, though, if you get something, you give something. You get to participate, to a point, on the upside, but if the rate reaches a certain level, you go back to the worst case.
The decision-making process
Your goals and strategy will determine your direction and inform your decision-making.
For example, if your business is a low gross margin business, and it is very difficult to change your price, you would likely predominantly select the forward exchange contract. That gives you certainty, and because you can’t change your pricing easily, the impact of foreign exchange movement could be material.
If you are at the other extreme, with a high gross margin and prices you can easily change, FX options could be a good alternative.
If you’re in the middle, with high margins and fixed pricing, or low margin with the ability to change your pricing, you might consider either forwards or options. This scenario gives you the flexibility to look at different types of products.
The scenario that fits your business situation can potentially guide you towards what product(s) you might consider.
The WHAT of Hedging:
Choosing a hedging product or structure that aligns to your strategy and your hedging policy
This is the introduction to the three-part series, The WHY, HOW and WHAT of Hedging Currency Risk.
To learn more about currency hedging and risk management, please contact us.
Investment products carry a high degree of risk and are not suitable for everyone. You should be sure that you fully understand the risks to determine if it is right for your company.
If you are unclear, you should seek third party advice.
This communication should not be viewed as an influence to trade in investment products. Corpay does not offer advice in every jurisdiction in which it is licensed. Please refer to our Licensing and Regulatory Information document for detailed licensing information.
Investment products carry a high degree of risk and are not suitable for everyone. You should be sure that you fully understand the risks to determine if it is right for your company.
If you are unclear, you should seek third party advice.
This communication should not be viewed as an influence to trade in investment products. Corpay does not offer advice in every jurisdiction in which it is licensed. Please refer to our Licensing and Regulatory Information document for detailed licensing information.
“Cambridge Global Payments” and “AFEX” are trading names that may be used for the international payment solutions and risk management solutions provided by certain affiliated entities using the brand “Corpay”. International payment solutions are provided in Australia through Cambridge Mercantile (Australia) Pty. Ltd.; in Canada through Cambridge Mercantile Corp.; in Switzerland through Associated Foreign Exchange (Schweiz) AG; in the United Kingdom through Cambridge Mercantile Corp. (UK) Ltd.; in Ireland and the European Economic Area on a cross-border basis through Associated Foreign Exchange Ireland Ltd.; in Jersey and the Channel Islands through AFEX Offshore Ltd.; in Singapore through Associated Foreign Exchange (Singapore) Pte. Ltd. and in the United States through Cambridge Mercantile Corp. (U.S.A.). Risk management solutions are provided in in Australia through Cambridge Mercantile (Australia) Pty. Ltd.; in Canada through Cambridge Mercantile Corp.; in the United Kingdom through Cambridge Mercantile Risk Management (UK) Ltd.; in Ireland and the European Economic Area on a cross-border basis through AFEX Markets Europe Ltd.; in Jersey and the Channel Islands through AFEX Offshore Ltd.; in Singapore through Associated Foreign Exchange (Singapore) Pte Ltd. and in the United States through Cambridge Mercantile Corp. (U.S.A.). Please refer to http://cross-border.corpay.com/disclaimers for important terms and information.
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