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How to Hedge FX Risk to Manage International Currency Fluctuations

July 29, 2021
(Photo credit): Klaus Vedfelt

Businesses working overseas can use foreign exchange (FX) tools to manage risk in their business operations and maximize profit.

As geopolitical issues and trade tensions persist amid the uncertainty of coronavirus impacts and the potential for future outbreaks, companies with global subsidiaries are utilizing various financial instruments to insulate their balance sheets from volatility and other fluctuations.

Companies whose clients and vendors include international markets must be prepared for several factors, including the impact of foreign currencies, regulatory issues, foreign taxes and the political climate of the local markets.

Not only will a company’s revenue and expenses be impacted from fluctuations in the currency markets, their cash flow and investments will face also uncertainty.

Typically companies that generate revenue of USD $15 million to $300 million in sales are well-positioned to benefit from implementing foreign exchange services, especially ones with exposure in working with clients and vendors in Europe, Latin America and Asia, says Michael Hayashida, senior managing director and head of foreign exchange (FX) risk management at East West Bank. However, many companies well above or even below the revenue range could also benefit significantly.

Why foreign exchange tools benefit the bottom line

Foreign exchange tools benefit companies dealing with purchasing or selling products from overseas suppliers or customers. Since these companies will have to make international payments, many mistakenly believe that if they deal in USD, they are insulated from FX risk. However, the reality is that a company’s international payments are still subject to FX risk, Hayashida says.

“A lot of companies do benefit from using the USD, but once beneficiaries receive the money, they will need to convert it back into their local currency upon receipt,” Hayashida says. “Sometimes companies build in a risk cushion and pass on risk to their customers.”

Having an FX strategy can help companies avoid shelling out more money for expenses, while streamlining their global payment process, potentially increasing their profit margins, or meaningfully reducing their expenses. It should also be part of a company’s broader risk management plan.

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A change in foreign exchange rates can have an important impact on a company’s performance and can increase risk, says Binyam Taddese, an MBA adjunct professor at the Cox School of Business at Southern Methodist University who is also a rates and credit analyst with Trust Capital in Mumbai, India.

“Changes in exchange rates can potentially reduce a company’s expected future cash flows and reduce its value,” Taddese says. “Effective management of foreign exchange risk can also reduce the variability of future cash flows, improving the planning capability of the firm.”

Knowing how to deal with currency fluctuations can help a small to medium-size business mitigate its impact on their business operations, Hayashida says.

“Once companies start to recognize there is some risk, they often do not know what to do,” he says. “If today, for example, the Chinese renminbi’s exchange rate is 6.5 relative to the USD, by the time a company makes the actual overseas payment, say in a couple weeks, the Chinese currency could then have appreciated against its U.S. counterpart, potentially making that same international payment significantly more costly than it would be today. In short, a company’s USD payment could be eroded because of exchange rates. The uncertainty of fluctuating foreign exchange rates is what creates currency risk.”

Businesses face different types of foreign exchange exposure, including transaction exposure, Taddese says. Transaction exposure arises from existing contractual obligations entered prior to an exchange rate change but not settled until after the exchange rate changes. “This can result in changes in the actual cash flow of a business and can have a direct impact on the value of a business,” he says. For example, if a firm sells goods to a foreign buyer on credit with payment due later, the firm faces transaction exposure because the exchange rate at the settlement date will likely be different than the current exchange rate.

Forward contracts

Companies can use a range of FX tools to manage risk, including forwards, futures, swaps and options. Firms can also hedge their risks using FX tools, since hedging can reduce or eliminate loss.

“The foreign exchange market is generally very deep and liquid, allowing firms of all sizes to manage their foreign exchange risk exposure,” Taddese says. “However, firms must first understand and measure the foreign exchange risk they face, decide on their risk tolerance and which exposures to hedge, and then use available FX tools to hedge their exposure.”

While some companies will opt for spot trading, such as sending euros to a customer, other businesses are conducting more complicated transactions. While sending payments to a customer in the European Union may appear to be simple, the currency markets are in a “constant state of flux,” Hayashida says. “Depending on when you buy and sell currencies, you could be at a potential disadvantage if the markets are moving against you.”

Hedging tools can protect a company’s investments and cash flow. One option that is commonly used is a forward contract, which is when a rate of exchange is locked-in today in anticipation for a future payable or receivable amount, he says. A forward contract can provide a company certainty with respect to the cost impact of its international payments.

“You are locking in the USD value of the international payment,” Hayashida says. “You know what the cost is going to be upfront. You have the security in knowing what the FX rate is going to be, which in turn provides peace of mind and certainty when the international payment is ultimately needed—whether it is three business days in the future or up to two years later, and potentially beyond.”

Companies prefer forward contracts because they operate on the principle of “buy now, pay later.” This provides companies more predictability in their cash flow, allowing them to avoid paying for the FX conversion upfront, while still protecting them against downside risk by locking in the exchange rate, Hayashida says.

“You have peace of mind in knowing the conversion rate upfront. The forward contract, if used appropriately, can help take the uncertainty out of the picture so customers know what their expense is, which is useful for budgeting and calculation purposes,” Hayashida explains.

How New Vision Display used forward contracts to their advantage

Since New Vision Display was founded in 2012, it has always used a FX strategy, says Alan Lefko, CFO of the company, which manufactures liquid crystal displays and modules for original equipment manufacturers.

Since all of their customers trade with the company in USD, New Vision Display leverages the currencies that are not USD, Lefko says. In China, the company’s payroll and utilities are paid in renminbi and USD. Most of the raw materials they purchase are paid in USD.

New Vision Display wants to leverage the renminbi and not have it incur losses, Lefko says. Since the company also has offices in Europe, they take positions on the EUR (euro) and GBP (British pound sterling) and watch those two markets from a USD standpoint to make sure they are optimizing their exchange rate.

“With the pandemic and commodity shortages, we faced cost increases and used an FX strategy to hedge our trading loss in terms of conversion,” Lefko says, adding that the company entered into forward contracts at advantageous rates and sold some of the contracts to mitigate some of its FX loss in China.

“We would have taken a bigger exchange loss of renminbi since our only source of it was by selling USD to buy it,” Lefko explains. “We have done the same thing in the U.K. with the GBP/USD and bought a forward contract to cover 70% of our GBP spend for the next 12 months. So far, the strategy has been working and the ease of operations with East West bankers is incredible.”

(Photo credit): Merdan
“You have peace of mind in knowing the conversion rate upfront. The forward contract, if used appropriately, can help take the uncertainty out of the picture so customers know what their expense is, which is useful for budgeting and calculation purposes.”

-Michael Hayashida

Currency options

Some companies opt to use currency options, which give them the right, but not the obligation, to buy and/or sell currency at a specified point in the future, at an agreed upon exchange rate.

“This can be seen as the most flexible option, but it comes with a cost,” Hayashida says, because using a currency option is similar to paying an upfront premium, much like an insurance policy.

“You pay whether you utilize that policy or not, but you have the peace of mind in knowing that you’re fully protected,” Hayashida continues. “There is no expectation that you have to exercise it. In the event that the worst-case scenario comes into play, you have that ‘insurance policy’ you can exercise to give you the protection of downside risk.”

One tailwind is that if the market were to move in a company’s favor, they can choose to participate in that upside movement and let the insurance policy expire worthless.

“It gives more sophisticated clients flexibility, since they often have a view of where the market is headed, and it can protect them against a worst-case scenario,” Hayashida says. “The market could move in their favor, potentially further enhancing margins and profits.”

Currency options were designed for situations with greater uncertainty. For example, one U.S. company was bidding on an overseas construction project to install solar panels in Germany but did not know if they would win the bid for the project, which meant that the currency exposure was risky, Hayashida says.

“The currency option can be a great tool that allows them to hedge in case they are awarded the project,” Hayashida says. “They can pay the insurance premium just in case and can swap it into another currency hedge for the future. If they lose the bid, there is no harm or foul.”

The upfront premium is the only investment that the company made, and depending on which way the markets go, that option could have monetary value, he says. The company could also liquidate that policy and recoup some of that initial expense. However, the bottom line ultimately is how much uncertainty and risk tolerance a company can cope with.

“For some customers, the more certainty they have with the timing and size of payment, the more comfortable they are and could be more inclined to use those tools,” Hayashida says.

Determining the right customized FX tools

Other FX products include hybrid or structured derivative FX products that allow customers to have more flexibility, while reducing (or eliminating) upfront cost—in short, a customized FX risk management strategy can be developed by “mixing and matching” various FX hedging products, based on their risk tolerance or objectives.

Since buyers of currency options have to pay a premium, the ones that find it unpalatable and do not want unlimited protection for the next three to six months can choose to cap and limit the upside participation and reduce or eliminate the upfront premium. Instead, they can pay for an option that creates a “ceiling and a floor” that creates a range that is called a collar or range forward, which reduces (or eliminates) the upfront premium.

“This is ideal for someone who wants some wiggle room and doesn’t want to be locked into one rate,” Hayashida says.

These products are structured in duration from three business days to upwards of five years—depending upon the currency pairs’ liquidity and availability of internal credit support. They can be useful to companies that are conducting mergers and acquisitions, especially deals that are sensitive to FX movement and need bankers to monitor currency levels on their behalf, he explains.

“We can mix and match products depending on a company’s risk appetite and investment objective, cash flow consideration and credit worthiness,” Hayashida says.

Contact East West Bank FX Team

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