• Alex Axentiev, Co-Founder at HedgeFlows


• 15.06.2023 11:00 am
#finance

In today's global economy, businesses engaged in international trade must proactively address the challenges presented by foreign exchange risks. Fluctuations in currency values can have a significant impact on a company's cashflows and profit margins. To effectively navigate these risks, finance managers and directors must employ strategic measures, including establishing accurate budget rates and implementing appropriate hedge ratios.

Budget Foreign Exchange Rates: The Key to Proactive Risk Management

Budget rates serve as internal tools that enable finance managers and directors to forecast future margins and cashflow needs in the presence of foreign currencies. Failing to establish realistic budget rates can result in uncompetitive pricing, diminished profit margins, and potential losses. 

While accurately forecasting exchange rates is challenging, relying solely on bank or financial provider forecasts or cushioning current market rates can be unreliable, akin to flipping a coin. The resulting budget rates may not align with actual exchange rates, potentially jeopardising a company's profitability.

To manage budget rates effectively, the best practice is to secure foreign exchange forward contracts for future dates that closely align with the initial budget rates. By fixing effective exchange rates, businesses eliminate the risks from fluctuating market rates, providing more certainty and reducing costs and profit margin erosion.

Fluctuating Forecasted Transactions: Hedging for Uncertainty

Budget rates are particularly useful when future cashflows are uncertain, such as when sales or purchase orders in foreign currencies have not been invoiced or when specific commercial transactions are yet to occur. In such cases, accurately predicting the amounts and timings of future foreign cashflows becomes challenging. 

To strike a balance, finance teams commonly hedge a portion of expected future cash flows, focusing on those with a high probability of being required within a specific period. This practice, known as the minimum hedge ratio, helps mitigate the risk of over-hedging, which can lead to unnecessary costs or limited flexibility. 

For instance, if at least 50 per cent of orders are expected to be paid in a foreign currency within the next quarter, it is an accepted practice to hedge such an amount.          

On the other hand, a company may want to take advantage of market moves and lock rates when they are good. But hedging too much may lead to unintended consequences and equally result in losses too. To avoid over-hedging, when the effective exchange rates align with the company's profit margins, at their recent best,     the maximum hedge ratio should be considered as a predefined limit.     

Hedge Ratios over Differing Periods: Balancing Certainty and Flexibility

Ensuring that hedges keep within the planned minimum and maximum hedge ratios      enhances the certainty of effective rates and facilitates more accurate planning. It is typical for recommended hedge ratios to be lower for more distant future periods due to increased uncertainty surrounding exchange rates. As time progresses closer to the current period, the hedge ratios increase, providing greater certainty for immediate exchange needs.

Combining Foreign Exchange Hedging and Hedge Ratios: The Path to Stability

By implementing and adhering to robust hedge ratios, businesses can ensure flexibility in their budget rates from one period to the next. As business needs become more certain over time, the hedge ratios dictate topping up the hedge amount, creating a new layer of hedge for each period. Since each hedge is executed at different rates, a blended effective foreign exchange rate is thus established for each period.

Successfully navigating foreign exchange risks is a fundamental aspect of conducting business in the global marketplace. By harnessing budget rates and hedge ratios, finance managers and directors can mitigate the impact of currency fluctuations on cashflows and profit margins. 

Realistic budget rates, secured through FX forward contracts, provide stability and protect against unexpected rate changes. Implementing appropriate hedge ratios ensures an optimal balance between risk mitigation and flexibility. By mastering these techniques, businesses can confidently navigate foreign exchange risks and position themselves for success in the international arena.