Buying or selling on the spot market can be a successful tactic, providing it remains on an upward trend. But if you look at the recent periods of extreme volatility, you can see the risks inherent in such strategies.
Shrewd businesses and individuals use hedging strategies to manage foreign exchange exposure and risk. If a business is not confident or comfortable in placing a hedging strategy, there are still a number of ways to mitigate risk:
- Renegotiate pricing with customers/suppliers
- Request to pay or be paid in GBP (have your customers or suppliers exposed to risk instead)
- Always try to net-off any FX exposures where possible
A best guess approach leaves your business exposed to currency fluctuations. But a hedging strategy reduces risk.
In simple terms, currency hedging is the act of entering into a financial contract to protect against unexpected or anticipated changes in currency exchange rates.
Benefits of FX hedging
1. Protection from adverse currency market movements
2. Easier forecasting – with more certainty over future prices
3. Improved customer relations thanks to consistency in pricing of products and services
4. Retaining profit margins budgeted against an FX rate.
Risks associated with FX hedging
1. Fixing the price can be a disadvantage if the exchange rate improves on the hedged price
2. Cash flow may be impacted, as you may have to pay deposits or premiums up front, along with margin calls.
Case Study: A UK Importer
A UK-based importer has procured stock from its Caribbean suppliers, which it will sell wholesale to UK retailers.
The supply chain cost base is USD denominated, with all revenues generated in GBP. So, the business is exposed to GBP-USD exchange rate fluctuations.
- The business wins a contract to supply a fixed number of goods per month, at a fixed price per good for six months. Because prices and volumes are fixed, the business cannot pass on any increased costs to the retailer if GBP-USD moves lower
- If GBP-USD has moved significantly between one contract period and the next, it is not always possible to pass on this full cost increase into the next price list. This is due to the competitiveness of the industry and can result in a losing margin
- In a rising GBP-USD market, the business needs to be able to offer discounts in line with its competitors.
- Mitigate risk of GBP-USD depreciating
- Gain extra margin from purchasing Dollars at a more favourable rate
- Consider the view that now Brexit has occurred, the Pound may continue to appreciate
- Find a solution that does not negatively affect business cash flow.
By understanding the commercial requirements and competitive pressures, the business implemented a flexible forward hedging strategy. This contract is an agreement to fix at an agreed rate of exchange on a predetermined amount of currency for delivery within a set window.
Fixing the rate of exchange gives protection from adverse currency swings to ensure a weakening Pound does not erode your profits. By using a flexible forward contract, the business is not tied into settling on its maturity date. This gives flexibility to take tranches of currency when you choose to help manage cash flow.
There is also flexibility to buy on spot should GBP-USD rates appreciate, helping a business gain extra margin or offer discounts over competitors’ prices.
Are you concerned about how currency fluctuations will affect your business? Register with Privalgo and talk to one of our Relationship Managers.