Looking beyond financial hedges

With the Australian dollar seeing high volatility, falling 20% against the US dollar in the last 12 months alone, it’s a foolhardy company that sticks its head in the sand and does nothing. 

Hedging tools can be critically important when it comes to managing your currency risk. Tools such as forward contracts and FX options can be of great value in giving you certainty and reducing your exposure.

But financial tools are not your only options. Effectively managing your forex risk often involves a combination of financial and non-financial hedging strategies. Let’s look at some of these non-financial strategies.

Matching costs to revenues

In 2007, former Airbus CEO Louis Gallois famously estimated that the Euro’s 10% appreciation against the US dollar cost Airbus one billion euros, because a large share of its costs were denominated in euros, while the bulk of its revenues were in US dollars. 

According to RBA data, nearly 80% of Australian merchandise trade is denominated in foreign currency. This means that movements in the exchange rate can also affect the cash flows of trade-exposed firms by altering the AUD value of their trade payments and receipts.

Renegotiating the currencies you deal in with customers and suppliers, to better align them, can help offset currency risk.

“Leading and lagging”

This involves deliberately delaying payments if a favourable currency exchange movement is anticipated, but bringing them forward if a negative one is likely. With the Australian dollar currently on an apparent decline, you would want to pay foreign currency denominated invoices as quickly as possible before that foreign currency became even more expensive relative to AUD. 

Conversely if you were paying in AUD you could stretch things out, as your Australian dollars effectively became lower value relative to other world currencies.

Operational changes

Operational hedges refer to the geographical diversification of sourcing, production and sales. Choosing where you operate can make a big difference.

An example might be an Australian exporter to the US opening up a production facility in that market to match its expected sales revenue to its cost structure.

Alternatively a company might open a subsidiary in another country and borrow in that local currency to finance its operations. This matches the debt payments to expected revenues in that foreign market.

Natural hedges

These involve two types of investment or transaction that effectively cancel one another out. For example a superannuation fund might invest in a foreign currency asset that has a price that tends to be negatively correlated with movements in the relevant exchange rate.

Another example would be a gold miner that sells bullion in US dollars. Because a rising AUD correlates with gold prices, if the Australian dollar did rise against the US dollar, making the USD prices translate to lower AUD revenue, the price of gold would also have risen and offset this fall.

No single strategy can guarantee protection against currency risk. A particular danger comes when companies try to bet on currencies to profit from them. With the “leading and lagging” strategy if the expected currency direction goes against you, your costs could suddenly soar.

Hedging is about protecting yourself, not profiting from risk. When it comes to something as unpredictable and volatile as exchange rates, the smart strategy is a safe strategy, not a speculative one.

Will Shepherd is Treasury Manager at OzForex, a global supplier of online international payment services and a key provider of Forex news.