5 considerations when developing an FX hedging strategy

Strategy and tactics are two distinctly separate things.  Strategy involves planning the company’s next move.  Tactics involves putting that plan in to action.  Strategy is doing the right things – tactics is doing things right.

Most blog articles from large banks and FX providers mix up the two.  They describe hedging products such as forward contracts, options etc. as hedging strategies that can be used to manage risk.  A hedging product is a tactic…not a strategy.

There is actually very little written specifically on corporate hedging strategies even in the academic world.  This is interesting considering it is such an important and well publicised problem for businesses who deal in overseas markets.

 

The following five are key considerations to focus on in determining the hedging strategy for your business:

 

Capturing accurate data

 

For most SME and corporates without a treasury management system, this involves downloading a report from an accounting system, contacting your bank for a copy of your open contracts and compiling these in to one master spreadsheet.  Finance managers then decipher this data and determine the current exposure and enter into contracts to minimise this exposure.

Ensuring foreign invoices are actually entered into the finance system is the the first step in to the process otherwise the finance manager wont be able to see the full picture.  Ensuring your finance team understands the implications of quality data in to the ERP and the concept of a single source of truth is important.  Cloud based electronic invoicing is now easier than ever.  Check out Tradeshift SME’s and Enterprise buyers.

 

Understand hedge coverage ratios

 

Hedge coverage ratios are a simple way of measuring a hedging strategy. Hedge coverage ratios allow businesses to identify the percentage of their exposure that is hedged in periods or time buckets.

A very simple example could be a business may want to have 100% of their exposure hedged out 0-3 months, 50% out 3-6 months and 25% for 6-12 months.  Businesses can use these to measure their coverage over time and ensure they are sticking to their strategy.

 

Using budget rates to measure performance

 

Exchange rates are often set at the start of the financial year in the budgeting process to understand worst case costs and gross margins.  Budget rates are often used to benchmark performance.  For example, by understanding the weighted average rate of all of your forward contracts you can easily understand how you are performing above that in real terms.  Evaluating hedging products can then be done objectively to ensure that the business is always taking out hedging above the budget level.

 

Regular reporting of exposures      

 

A hedging strategy that can be applied objectively is important and doesn’t mean that businesses can’t act opportunistically if the rate moves significantly in their favour.  Typically, more sophisticated finance teams regularly review their exposures against their hedging policy and then take appropriate cover on a rolling basis as required.  All this leaves the CFO to do is to report to the board or management team that they are hedged within the guidelines set out in the strategy / policy which in turn covers them if there are large and unaccounted for movements in the market.

 

Hedge accounting treatment

 

Whilst it is out of the scope of this article to go into the intricacies of hedge accounting treatment for your hedging strategy, understanding the implications of this is vitally important as it may have implications for the types of products you may condone (tactics) and betters align the risk strategy with accounting.  In particular, a review of the changes from IAS 39 to IFRS 9 which is more principle based and less complex but with greater flexibility to apply.  A free checklist can be found through Rochford Capital.

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