Should your business hedge against inflation?

Get to know the FX strategies and hedging tools that can help you manage risk and adapt to changing economic conditions.

Inflation is front-page news around the world right now. It seems we are experiencing a perfect storm of
geopolitical events and the ripple of effects of COVID-19, where supply chain disruptions, a shortage of
key inputs, and fiscal stimulus have disrupted the supply and demand of goods and services.

Inflation is painful for consumers, but also has a negative impact on businesses. As the general price
level of goods and services increases a business faces higher costs, which reduces its ability to turn a
profit and remain competitive. Inflation also causes economic uncertainty which makes it difficult to
plan and formulate investment decisions. For example, a business may suddenly have to accommodate
a price increase from their manufacturer, who is also trying to minimize the impact of inflation, which
makes it difficult for the business to budget accordingly.

Inflation also affects currency exchange rates. Central banks might attempt to curb high inflation by
increasing interest rates, which can make a currency more appealing to investors and increase its value.
On the flipside, when inflation is low, interest rates simmer down and the currency value decreases. For
businesses that operate internationally, currency fluctuation can have a detrimental impact on their
ability to manage costs and cash flow. FX risk management, or currency hedging against inflation, is one
way to manage the impact of this volatility.

What is currency hedging?

When a business imports goods or services, a decrease in the value of the currency that the business
pays in can lead to higher costs. For an exporter, an increase in the currency they receive can have a
detrimental impact on revenue. Hedging forex is a strategy that can help businesses minimize the impact
of these market shifts on their operations. It involves the use of financial instruments to lock in
exchange rates for future transactions, which helps reduce exposure to the risk of volatile exchange
rates.

Let’s say a US-based business is importing goods from Europe in six months’ time. The currency
exchange rate is $1.20/€1 so the business plans for a cost of $1.2 million. However, if the euro
depreciates against the USD over the next six months, the business may end up paying more in US
dollars for the same amount of goods. To minimize this risk, the business could utilize currency hedging
to lock in the current exchange rate and ensure that it will pay $1.2 million regardless of future currency
movements.

What types of hedging tools are available?

FX risk management can provide a level of certainty and stability that allows a business to predict costs
and revenue streams more accurately, however, which financial instrument a business uses will depend
on individual objectives and risk appetite. The most common financial instruments include:

Forward contracts: A basic hedging tool that lets you lock in the current exchange rate for an agreed
period of time (up to 12 months). This provides exchange rate certainty however you are obligated to
trade at your chosen exchange rate even if the market shifts in your favor.

Future payments: This tool functions like a forward contract however, where the terms of a forward are
negotiable, the terms of a future payment are standardized in relation to quantity, delivery date and
settlement.

Options contracts: For businesses that are comfortable with an amount of risk, options contracts allow
you to lock in an exchange rate that provides protection from adverse currency shifts, while offering the
opportunity to take advantage of favorable shifts in the market. Some options contracts require
payment of an upfront premium.

It’s important to note these tools are derivative financial instruments that may expose a business to risk
should the underlying exposure being hedged against cease to exist. They may be suitable if the business
has a high level of understanding and accepts the risks associated with derivative financial instruments
that involve foreign exchange and related markets. If your business is not confident about understanding
derivative financial instruments, or foreign exchange and related markets, it is strongly suggested you
seek independent advice before making the decision to use these instruments.

Stay ahead of inflation

To succeed in an inflationary environment, businesses must be able to adapt to changing economic
conditions and manage their costs effectively. Currency hedging is a valuable risk management strategy
to help businesses minimize the negative effects of inflation. Using financial instruments like the ones
outlined above, businesses can position themselves to protect against adverse currency movements,
better manage cash flows, control costs and remain competitive in global markets.

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