A Fresh Approach To Currency Hedging
Hedging describes the different ways that Australian importers are able to protect their company against a fall in the exchange rate. There are actually many different ways to provide this type of protection though your FX provider is most likely to offer Forwards as the primary instrument. They may also mention Options or have their own names for option strategies such as ‘Smart Forwards’, ‘Zero-Cost collars’, ‘Rebate Forwards’ or even ‘Plain Vanilla’ options. It’s great to get to know how all of these work (and we will eventually) and where they might, if ever, be applicable to your business.
Unfortunately the mentioned instruments are probably the most used and misused solutions for hedging one’s currency exposure as it is most likely that the vast majority of these strategies won’t fit your business model, even if you are an aggressive market participant. We are going to understand this much better by the end of this ‘Hedging’ series but I suppose that as a primary rule, just remember that if you are considering a strategy to protect your currency exposure, if it doesn’t fit perfectly, don’t force it.
No Hedging : Spot-Only
Before we look at advanced hedging, let’s first understand the risks associated with not hedging your currency exposure at all. If we are not putting in place any protection with regard to our future currency payments, what we are doing is making a SPOT payment. This means that we are happy to pay the exchange rate on the day of the invoice payment. This is the strategy that most importers and exporters use simply because it’s the easiest (or laziest) strategy, though not necessarily the best strategy. For now let’s understand the risks and opportunities of this Spot-only payment method :
100% Opportunity, Zero Protection
Here we can see that if the exchange rate were to increase between today’s rate (1.02) and the date that we need to make a payment for an invoice, we are able to fully take advantage of this improved rate. Therefore, if the rate is at 120c on the date of payment, that is the rate at which we will transact. In this instance we are 18 cents better off (than had we locked in a Forward as we shall see in our next example). As such, if the rate heads down to 88c and we have ‘Zero Protection’ and thus will have to pay the invoice at this rate. Unfortunately, we are now 14 cents worse off! In some cases this could be our entire profit margin on this shipment.
From the above we can see simply that if we don’t put in place protection, we may be better off if the exchange rate improves, but worse off if the exchange rate diminishes.
To summarise : SPOT-ONLY PAYMENTS = 100% Opportunity with Zero Protection
Let’s expand on this a little… Zero protection put differently means 100% risk. There’s a good chance that when you signed up for overseas payments your provider neglected to tell you this important tid-bit about spot payments. One might believe that it should be a key part of their due diligence to do so, but in so many cases it’s not done. Without being explicitly told this, how are you supposed to know this? Currencies are not the core of your business. The actual product you sell to your customers is your expertise. So let’s make this a clearer part of your business.
Without hedging you have zero protection. This means you have 100% risk. With this also comes 100% opportunity to take advantage of better exchange rates (if they occur). Some might think that by doing nothing with regard to protection and hedging that you are actually taking the safest route, but it is actually the direct opposite.
Now that you understand that spot-only payments represent 100% risk, this is something that you need to address. In next month’s article we explain the mechanics behind a Forward Exchange Contract and thereafter begin to explain a number of advanced strategies, so be sure to read all articles in this currency hedging series.
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By Marcus Addison
Marcus Addison has over 15 years of experience in currency markets. He has worked in eTrading for the largest FX provider in the world, Deutsche Bank and has traded both as a Hedge Fund Manager and as a professional Proprietary Trader for the largest electronic derivatives group in Europe. He now focuses on using his trading and foreign exchange experience to help both importers and exporters wade through the currency maze with Addison Capital.