The optimum hedge coverage ratio for FX hedging

Businesses use hedge coverage ratios to measure the amount of hedging cover they have over time periods.  These ratios may be may be explicitly contained within a FX hedging policy or may be calculated and implemented informally.

Generally speaking, businesses involved with international trade will hedge on forecasted transactions or committed transactions (invoice or purchase orders) and the longer out the forecast the less they will hedge due to the greater uncertainty of the positions.

Very little in the way of data has existed on this topic until the recently published Delloites 2016 Global FX Survey which included specific questions relating to hedge ratios used by the respondents surveyed.

Overall there were no surprises – hedge ratios for businesses went from 68% for 0-3 months to 18% out further than 24 months albeit with a small number of companies that actually hedge that far out.

 

 

Businesses are all unique in the way that they hedge.  So what is the perfect hedge coverage ratio for a business?  The following are some considerations in developing a hedge ratio guideline for your business:

 

Historical accuracy of sales

 

For a business in a mature market with highly predictable sales YOY having a higher hedge ratio will make sense.  The reduced volatility in the P&L and greater certainty in cash-flow forecasting will make up for the potential opportunity loss from a favourable move in the exchange rate.

However, a business with a small customer base or operating in a highly competitive commoditised industry where customers can easily switch suppliers may want to take this into consideration when setting hedge coverage ratios.  Unwinding a hedge with a significant negative mark-to-market value can be costly!

 

Volatility in traded currencies

 

For finance managers, watching FX Rates might not be the best use of your time but having an understanding of recent movements often are useful for businesses in tailoring their hedge ratios.  For example, an Australian importer trading in US Dollars may use brackets or rate bands to alter their hedge ratios.

 

 

Taking into consideration the 5-year average of the AUD/USD is 0.9270 with the Aussie dollar currently trading around 0.7200, this strategy would see hedge ratios of 70% moving to 40% coverage out 6-12 months.   With all of this, the key is to remain objective and have a plan.

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