By Jamie Jemmeson ACSI, MSTA at Infinity International
This week the UK saw the reopening of non-essential retail shops, and while restrictions are being lifted the uncertainty and volatility faced by businesses remains. The current context could be an opportune time to consider the nature of the risk foreign exchange exposes your businesses to, as well as the impact of recent currency volatility, and then, against this backdrop, to re-assess the effectiveness of an existing hedging strategy.
We put forward 4 questions in our introduction to the series “Points to Consider Before FX Hedging in COVID-19 Conditions”. Last week, we tackled Question 1: “Can Your Business Identify and Understand its FX Exposure?”. This week we are going to unpack Question 2: ‘What impact could hedging have on your business?’
FX risk and the business impacted
Foreign exchange (FX) poses a risk to any business with an international trade exposure, the question is how does your business manage this risk (through hedging or by other means)?
The objective of hedging is to achieve certainty through fixed foreign exchange rates which can in turn protect a positive target margin. Under COVID-19 not only have many businesses experienced changes to the way they operate but many currencies have traded to extremes; for example, during the month of March, GBPUSD was more 13% lower than where it started the year as COVID-19 fears escalated.
Payments to international suppliers
Has the business changed its international suppliers during COVID-19 and would that allow netting of currency exposure?
Before COVID-19, many businesses would have had consistent supply chains. However, because of the pandemic many businesses have had to rethink what this looks like. If you fall into this category, has this changed the way in which you are paid by customers and pay suppliers for goods? By receiving foreign currencies that are outside of your reporting currency and using these funds to settle overseas invoices you may be able to net off (i.e. reduce) your FX exposure. In some cases, this could remove a business’ FX exposure altogether.
A pricing and profitability
Your profitability could be subject to numerous revisions if you have foreign currency exposure.
Currency fluctuations create a plethora of scenarios to plan for. In the setting of a FX move in your favour do you pass this improvement on to the end user to gain market share or does the saving improve profitability? This could come down to the price sensitivity of your end user to adjustment in costs as well as your agility to implement price fluctuations – how long does it take for this cost adjustment to pass through to price? An everyday example is the price at the petrol pump, where regardless of price drivers still need and will buy fuel.
We have previously highlighted the difference between budget level or costed level, and it will be important to understand if the business is working off a costed level. If it is, what flexibility does the business have to adjust costing as this could affect the end user cost and subsequently demand? It is key to really understand the purpose of hedging for your business environment.
Are you hedging to:
- Articulate the end costing of the goods/services to set price and understand profit margins?
- Ensure profit margins for a listed catalogue of prices?
A competitive advantage
Understanding the ways in which your competitors operate could influence the way you manage your FX exposure, and how you structure your approach to pricing and market share.
Questions worth careful consideration include:
- If your competitors take a dynamic approach to currency management could this result in them offering their product at more attractive pricing; and potentially capturing additional market share?
- Or, are your competitors taking a more passive approach to currency management which could result in them offering their product with a more rigid end user pricing structure reducing the impact on profitability but possibly limiting market share?
Hedging and its impact on your business’s working capital
Some FX providers often require some sort of collateral arrangement for FX hedging. This means cash from the business may be required either upfront (initial margin) and/or during the life of the hedge (variation margin) as the market valuation of the FX contract changes.
Any business needs to understand their balance sheet and what liquidity it holds to ensure it can fund the margin calls over the life of a FX hedge. This cash requirement would increase if a market move meant that the value of the FX hedge decreased. It would be important to consider if the payment of a deposit and/or variation margin may hinder other financial decisions.
You might consider the risk of an adverse movement in FX and whether that would outweigh the risk of collateral arrangements.
A failure to meet a request for variation margin could result in a reduction of other facilities or your provider closing the position and charging you for the loss.
The broader economy
There is a lot to consider when trying to understand the impact of hedging as it is specific to any business. We believe that questions like these can help to drive the discussion and start to build out a framework for your FX hedging strategy. There will of course be other variables at play, some of which are external. For instance, economic and political factors play a role in currency movements. However, questions surrounding currency volatility can be hard to answer especially amidst COVID-19 conditions.
We are closely watching how markets could react should there be a second wave of the virus as well as the increased tensions between the US and China. It’s important to consider FX risks in the context of the wider business environment; how these can be managed both within the business and through hedging.
Understanding how much, how far and when to hedge will also drive appropriate discussion and allow the business to come to a reasoned risk management framework.
We will consider this and more in next week’s Question: What hedging tools and what flexibility is available?
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Infinity International would be happy to offer a complimentary FX review of your current process to offer a fresh perspective and to highlight any areas that could be made more efficient. If you would like to organise a time for an exploratory conversation, please leave your details below.
The review would encapsulate:
- Strategy ideation to align FX risk management with your business objectives
- FX volatility assessment to understand the impact of a significant FX rate
- Credit terms to ensure efficiency for cashflow when hedging currency (subject to approval)
- FX pricing to determine your current cost of your current provider vs Infinity International rate
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This blog post is intended to provide you with information on the services Infinity International Limited (IIFX) offer and should not be interpreted as advice or as a solicitation to offer to buy or sell any currency or as a recommendation to trade. Foreign exchange rates provided therein are for indicative purposes only and are not intended to give an accurate reflection of current currency exchange rates or to predict future movements in currency exchange rates. IIFX is a company registered in England with registered number 06333730 and registered address at Third Floor, 24 Chiswell Street, London, United Kingdom, EC1Y 4YX. IIFX is authorised by the Financial Conduct Authority under the Payment Service Regulations 2017 (FRN: 567835) for the provision of payment services. IIFX is authorised and regulated by the Financial Conduct Authority in the conduct of designated investment business (FRN: 671108).