Hedging currency risks. Planning ahead to be better protected.
Currency fluctuations can have a major impact on business results. That's why many companies choose currency hedging. Anja Burford, Head of FX Sales for SMEs and Banks, discusses forward transactions and derivatives and explains the optimal way for clients to hedge.
Ms. Burford, is there such a thing as the perfect method of currency hedging for every client?
Anja Burford: The perfect method of currency hedging does not exist because every company works differently and has different expectations when it comes to hedging its currency risks. Since products in the area of foreign exchange trading can be tailored to meet the needs of our clients, there is an appropriate means of hedging for every situation.
The key factor is what goals the client wishes to achieve. Take, for example, a foreign currency buyer. Does the client only want to hedge against rising rates? Would the client like to benefit from falling markets despite being hedged? Then again, does the client wish to take a risk and buy the currency at a favorable rate?
Last year's study on exchange rate development revealed that although many clients want to optimize, they do not want to speculate. How do you find a balance?
That is precisely the challenge. Although true hedging like forward transactions does protect clients from any foreign exchange losses, it does not allow them to benefit from favorable market developments. Hedging products that do let clients benefit are associated with direct or indirect costs. In our experience, many companies are not prepared to pay a premium, though.
One solution to this problem is offered by other products in which clients optimize their cash flows or accept a degree of uncertainty over the hedged amount. We generally recommend they choose various products to gain some diversification.
The main priority is always to protect the clients.
Anja Burford, Head of the FX Desk for SMEs and Banks
What is the ideal way of combining them?
I believe the optimal strategy for clients involves forward transactions. With a conventional forward transaction, I buy a foreign currency – let's say euros – at a fixed rate twelve months out. Forward transactions can be supplemented using derivatives. Derivatives are a good way to hedge or optimize using options. Such optimization is generally used as a supplement and may provide extra performance. However, the main priority is always to protect the clients. I don't even consider optimization until after that.
Why do you like to use derivatives?
If you have conventional forward transactions, then you need to deliver for virtually every maturity. It's not that you can – you have to. That means you are under obligation to accept the contracts. With derivatives, you have the option of restructuring. In other words, you can restructure by extending the maturity or increasing the volume of the derivative. This gives clients more leeway than with a conventional forward transaction.
Nevertheless, many clients prefer to optimize. Why is there such a push toward optimization in Switzerland?
Optimization allows clients to buy or sell a currency at a very favorable price. There are two scenarios we typically see: Clients who are addressing the issue of hedging and optimization early on and are trying to use optimization to create added value, and clients who are forced to respond to a major movement since they've missed out on their budgeted rate. Optimization also poses risks, however, and it offers no protection since it could deteriorate. Generally speaking, we always suggest planning early and combining products. A combination of hedging and optimization is ideal.
Optimization is not hedging.
Anja Burford, Head of the FX Desk for SMEs and Banks
When does optimization make sense for a company?
Optimization generally makes sense when markets are relatively calm and can be highly attractive for clients. The risk that comes with optimization should not be underestimated, however. That is because optimization is not hedging. It is important for clients to tailor optimization to their company's strategy. We normally recommend that they carry out optimization only for part of what they require. That means the process is mainly suitable for companies that have a sufficiently large demand for foreign currencies or Swiss francs.
How do you recommend companies go about currency hedging?
It is crucial to plan early and assess their cash flows. The first step is to identify the currency risks in the foreground. Then, the company needs to determine whether the risks should be hedged and to what extent. Before hedging can be carried out, there is also the question of timing, i.e. when the cash flows will occur and the timeframe when the currency risks are to be hedged.
It is also imperative to clear up the issues of need, volumes, and time. After all, the better our clients know what they need, the sooner we at the bank can offer the right solution to the company.
Once these issues are cleared up, what do you start with in your consultation?
Once their hedging needs are clarified, it is important to get the client's market expectations. Different products are considered based on these market expectations. Forward transactions are still the most popular product. Other products may also make sense, though. It is important for the client to understand the different scenarios and risks. This is also fundamental for more complicated hedging or optimization in particular. Many turn a blind eye to the risks, but it is important for clients to already be aware of them in the planning stage of their hedging strategy.
How can clients minimize these risks?
Unfortunately, clients often wait until it's already too late to approach the bank. Clients are much more aware of political events and changes in the market nowadays. They are much more attuned to the markets. This is only true in terms of operations, though – not strategy. But clients should have a strategic dialogue with the bank at regular intervals. The markets can change very quickly now, after all.
As such, it is important to periodically discuss changes in the markets and their own strategy. The sooner and the more often clients have this strategic dialogue with the bank, the more successful they are with their own currency hedging.
In some Swiss SMEs, foreign currencies make up only a small part of their turnover. Can companies like that forgo currency hedging?
Currency hedging is worthwhile for any company, regardless of size. Even small amounts can easily be hedged. More complicated hedging strategies or approaches to optimization only make sense when a company reaches a certain size. Aside from currency hedging, there are also other exciting products such as a dual currency deposit, which can be used in cash management. The regional approach we take through our branches in the various regions enables us to be close to our clients and discuss the various options with them.