Smart approach to mitigating foreign exchange risk

The meteoric rise of the Australian dollar since the GFC has severely affected Australian importers and exporters. It can be a particular challenge for Australia’s 1.2 million small-to-medium enterprises.

The parity problem

Since early 2011 the Australian dollar has danced around parity with AUD/USD hitting lows below 0.9400 and highs in excess of 1.1000. A company selling $A100,000 and buying USD would have seen a $US16,000 difference in costs over this period.

With AUD/USD having recently stayed above parity since June last year, many sellers of AUD have been content to ride the wave and buy USD cheaply.

But how long will the Australian dollar’s strength last? Companies often become complacent when the “good times roll”, swapping common sense for optimism, and believing a strengthening AUD will continue forever.

Optimism vs objectivity

Likewise, buyers of AUD often refuse to believe that a currency move against them will continue, and that short-term pain may quickly change to their advantage. Optimism again replaces objectivity: the market rises, and a minor issue balloons into something far worse, increasing costs, cutting profit margins and hitting the bottom line.

Experience shows that many companies only take an interest in FX rates when it’s already too late, and the market takes a turn for the worse. Smarter companies are those that plan ahead, who take FX risk into consideration, and who realise that even smaller, unlisted companies need to hedge FX risk and protect themselves.

Better protection

So how can a company better protect itself from FX volatility? By understanding what the risk is, following a few simple rules, investigating the FX hedging tools available, and choosing a hedging strategy which best matches their needs.

The smart approach to FX hedging is simple. First, you need to understand the link between a company’s costs and FX risk. Most businesses, whether product or service orientated, fall into two cost categories. Some costs are relatively static over a certain period, whether a financial year, or the lifecycle of a project. But other costs are more fluid, and move around on a weekly or even daily basis.

Hedging strategy

To establish a hedging strategy, a business needs to recognise whether its costs are of the fixed or fluid variety. Those with static costs will have greater opportunity to lock in FX rates in advance.

For example: a plastic bags manufacturer has a year-long contract to supply a supermarket with a set amount of units each month. Therefore the manufacturing company knows in advance how much Polyethylene to buy each month. If it imports polyethylene in USD and agrees to a 12-month contract with its supplier, the FX risk will be the underlying changes in AUD/USD.

During the 12-month period, FX rates could move the actual cost price far from the budgeted cost price. So the manufacturer might consider locking into a string of 12 single FX deals each month, matching the payment schedule. This mitigates downside risk, locking prices down for the 12-month period.

This means that the manufacturer wouldn’t benefit from favourable currency movements, but the peace of mind gained by avoiding unfavourable ones is arguably more worthwhile. Likewise if new contracts are won, additional cover can be bought and hedging topped up.

Flexible vs fixed costs

Businesses with flexible costs are better suited to a hedging strategy which is equally flexible. For example, would a tour operator, with tight profit margins and a constantly evolving cost line, benefit from locking in forecasted costs 12 months in advance? The answer is doubtful.

A smart business would instead consider a dynamic hedging strategy, using a number of products to give a blended or average rate over the full year period. A dynamic hedging strategy requires consistent vigilance of currency market movements on an ongoing basis.

Those organisations which recognise the threat posed by FX risk and form a considered approach on countering these risks, regardless of complexity, will be the smart ones.

Jim Vrondas is chief currency and payment strategist, Asia-Pacific, at OzForex, Australia’s leading international payments solution provider.