By Jamie Jemmeson ACSI, MSTA at Infinity International
In the previous blog we addressed the ‘What impact could hedging have on your business’, where we unpacked some of the difficulties of recognising your exposure and having the ability to accurately forecast during these COVID conditions. Given the current backdrop in the UK, now could be an opportune time to consider your framework for managing your foreign exchange risk and what level of flexibility you require. In short, given the current circumstances does your current approach offer you the flexibility you need?
Before addressing the flexibility which various products can provide, it is important to take note why this could be significant in the second half of the year.
- Concerns of COVID second wave – data from the US is starting to prompt fear of a second wave which could weigh on sentiment and impact currency markets.
- Brexit “No Deal” re-emerges – the UK have declined on extending the transition deal beyond 2020. Recently PM Johnson stated that the UK would be prepared to accept an Australia-style Brexit trade deal, which is not considerably different to a ‘no deal’ Brexit.
- UK monetary policy – The possibility of negative interest rates is still not being ruled out by the Bank of England as a policy tool if the economy takes a turn for the worse.
The above factors could have an impact on currency volatility as well as the supply and demand of goods. If this happens, as a business you may require additional flexibility with your currency requirements to account for the unknowns and any impacts to your supply chain.
Two of the popular instruments used for FX hedging are:
This product allows you to fix a price based on the current market rate for buying or selling currencies on a specified date in the future.
Depending on your business and experience, you may be able to use structured products (e.g. FX options). Some of these products combine the benefit of a fixed rate of exchange whilst providing the opportunity to benefit from advantageous market movements.
However, the saying “there is more than one way to skin a cat” becomes relevant when we look at these two hedging products. Some of these products can come at a greater expense – so this is something the business will need to consider.
Other key factors you may wish to consider are:
- How much should you hedge?
- How far forward should you hedge?
- And what level of cover is important for the business if volatility increases?
Every business is different, and the dynamics here may be dependent on factors which include the sector you operate in, your supply chain and the availability of resources.
For example, if you are a business where your clients are not sensitive to price you might be able to have a less structured FX hedging strategy as you can pass the cost onto the end user without losing market share.
On the other hand, a business where clients are more sensitive to price could lose market share if pricing doesn’t remain competitive. Such businesses might favour a strategy that protects a worst-case scenario but gives flexibility to benefit from favourable market moves.
Another factor which could be considered is knowing what level of flexibility your business will need. Are you invoiced on a regular or an ad-hoc basis? Are your suppliers reliable with the delivery of goods or do you routinely experience delays? These factors can help you begin to determine what level of flexibility you may need in your FX hedging strategy.
Below are two examples of how flexibility can be achieved through FX hedging:
A layering strategy is a systematic approach to currency management that can remove part of the emotion from decision making. This involves using hedging products with different maturity dates instead of a single FX contract that covers the entire time period. This process can be repeated on future dates resulting in multiple FX contracts maturing on a specific value date. With all products in conjunction with each other, this provides you with a blended rate of exchange.
However, you could adapt the approach if currency volatility increases or decreases. This may include blending the hedging product with spot contracts or buying a larger tranche if the rate is at a favourable level.
A portfolio approach to hedging generally involves combining multiple product types (e.g. spot, FX forwards or structured products) in a manner that fits the company’s approach and appetite towards hedging and flexibility.
In practice, this may involve hedging some of your exposure with hedging products (e.g. FX forwards or structured products) and leaving a proportion unhedged. This unhedged exposure gives some flexibility by allowing you to transact through spot contracts as and when required.
Given the current economic climate, it is likely that making decisions in relation to managing your FX exposure is more challenging when compared to normal business conditions. Developing an FX hedging policy that provides your business with the right level of flexibility is not an easy task. As demonstrated in this insight series, there are multiple variables to consider from FX instruments and strategy, right through to the business’ cash flow position and potential outcomes for the end user.
If you missed the previous articles in this series, you can catch up:
Our next and final article in the series will answer the question, ‘What facilities are available to your business?’
*Structured products (which include foreign exchange derivative products) can carry a high level of risk and may not be appropriate and/or suitable for everyone. If you are in doubt as to the suitability or appropriateness of any product, Infinity International Ltd (IIFX) encourages you to seek independent financial advice.
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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We’re here to cut through the clutter and industry jargon to provide you with relevant information so you can build your understanding of foreign exchange markets.
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).