Hedging foreign exchange risks in uncertain times
The COVID pandemic has made life difficult for companies for nearly two years now. Long-term planning, such as in currency management, is barely possible anymore. In spite of the rising number of vaccinated persons in the population, this phase appears to be dragging on longer.
Given the above, the question arises of how companies can manage their foreign exchange risks in the best possible manner. "In this uncertain situation, it is important for companies to remain as flexible as possible so they can adapt to the constantly changing environment," says Maxime Gineys of FX Sales Swiss Corporate Clients at Credit Suisse.
He draws three practical conclusions about currency management for companies:
- Do not commit to amounts that are too large.
- Do not cover 100% of the requirements in all cases.
- Do not to enter into any obligation for time periods that are too long unless absolutely necessary.
Adapting hedging strategies to own requirements
"A company should always take various future scenarios into consideration when looking at currency hedging, assess their potential implications, and then implement a strategy that reduces the risks," explains Maxime Gineys. That is why it is essential for businesses to always analyze the current situation together with their personal FX advisors and set a specific target for the amount of hedging.
"The most important thing is to assess the requirements correctly by also simulating the foreign exchange flows for the worst-case scenarios," says the FX specialist. He recommends that companies pursue a dynamic approach and define several levels for a standard forward, risk reversal or participating forward on the basis of the current spot rate. On this basis, companies could then define a customized hedging solution for their own requirements in a next step.
Flexible hedging of foreign exchange risks in 2022
One important aspect of currency hedging for every company is the management of the risks. A high level of flexibility is particularly valuable in the currently uncertain environment. It allows companies to benefit from favorable market movements, while simultaneously providing protection if negative events occur.
"One solution that meets all of these criteria is the participating forward," says Maxime Gineys. "This strategy allows the company to hedge 100% of its exposure, but it only enters into an obligation for 50% of the amount." This means that the company is hedged at the pre-defined level. At the same time, it may benefit as a seller from upward movements in the foreign exchange rate or as a buyer from downward movements.
A second effective strategy is a risk reversal or a so-called collar. In this case, an exchange rate is fixed within a specific range. "We start by defining a floor and cap together with our client," explains the expert. "Then, on the basis of the direction of the transactions, one of the two strike prices is used to hedge the exchange rate. The other price represents an obligation." That gives the company the certainty that the exchange rate will not fall below the lower strike price or rise above the upper strike price.
Example of a hedging strategy using a participating forward
A company hedges itself to buy EUR against CHF at a rate of 1.06. Every month, there is an expiry date, with EUR 200,000 being protected. This means that if the EUR/CHF spot rate is higher than 1.06 on the expiry date, the company is fully hedged and can buy the EUR 200,000 at a rate of 1.06. However, if the spot rate is below 1.06, the participating forward means that the company only needs to purchase 50% of the amount – in this case EUR 100,000 – at a strike price of 1.06. The company can then choose to buy the other half on the market at a better rate to achieve a more favorable average exchange rate.
What are the important aspects of hedging strategies?
The optimal hedging strategy for each company is different, but there are three key points that companies should take into consideration when hedging their foreign exchange risks:
- Having no hedging at all is equivalent to speculation. It's the same as betting that the exchange rate will develop favorably.
- Hedging 100% of the company’s foreign exchange requirements is not always the best strategy and may, in the worst case, lead to additional difficulties, such as an unexpected change in exposure. By contrast, partial hedging, combined with dynamic monitoring and a flexible hedging ratio over time, can reduce these risks.
- Waiting for a good opportunity to buy or sell foreign currencies is pure speculation and a risky strategy. There are no guarantees that a price decline or rise will end at a specific point in time. In fact, to achieve foreign exchange gains, companies should consider targeted outperformance strategies.
Hedging foreign exchange risks makes sense even with low volatility
Overall, 2021 was characterized by low volatility in the main currencies. That is why a strategy in which future foreign exchange risks are not hedged remain risky, says Maxime Gineys. "In fact, now is the right time for companies to hedge their own exposure. During a phase of low volatility, risk hedging is always cheaper, particularly with foreign exchange structures that combine options." Therefore, it is an attractive opportunity to hedge foreign exchange risks.
In an environment that is calmed by the central banks, the market also anticipates a lower risk of fluctuations. "But that doesn’t mean that there won't be any fluctuations," explains the FX specialist. Furthermore, many central banks may reduce or discontinue their quantitative programs in 2022 and start hiking their interest rates, which would increase volatility. "Therefore, it should be in the company’s interest to hedge its exposure instead of exposing itself to additional risk."