The only thing that’s certain about foreign exchange markets is uncertainty. Geopolitical tensions, economic conditions and unforeseen events like climate or public health disasters amount to a constant state of flux. And that means volatility in financial markets.
When currency risk is high, enterprises need to be aware of their exposure and develop, implement and manage a clear, thorough plan to navigate these challenging times. Effective hedging programs should no longer be a luxury; they are a necessity amid increased uncertainty.
Why do you need a hedging program?
Global currencies constantly fluctuate, and any organization that trades across borders, accepts payments in foreign currencies or holds financial assets abroad should consider implementing an FX hedging strategy.
Unfavorable shifts in global conditions can result in sudden losses that could damage an organization’s growth goals and take years to recover from. A good hedging program can protect an organization against these shifts by reducing risk through market and currency fluctuations using various financial instruments, but it has to be done right as there are also risks involved with trading financial instruments.
Three components of a good hedging strategy
While FX hedging programs are essential in times of high volatility, they’re not a simple solution. Foreign exchange hedging requires a solid understanding of complex financial concepts and comes with potential downsides, when not thought through.
Financial products aside, a good hedging program will consist of three key elements.
1. Solid objectives and a clear action plan
Organizations must ensure they’ve outlined their objectives clearly and follow a disciplined plan that considers both their future needs and their immediate goals. These are some questions to keep in mind:
- What do you hope to achieve through your hedging program?
- What are your business needs?
- What are your underlying FX exposures?
- Do you have a solid understanding of your company’s financial health? What do the cash flows look like?
Regardless of your goals, a clear long-term plan based on data will help you stay on track.
“First and foremost, develop a plan,” explains David Renta, Global Head of Hedging at Convera. “Too many times in the past I have seen companies that have struggled with getting data around what their underlying exposures are, and when they develop a plan and then they can’t stick to it.”
In order to avoid this, Renta advises to partner with experts, who can help understand those exposures and develop a hedging program, together. “Then, once you […] get that set out, make sure to give yourself enough flexibility not to miss opportunities but also, stick to the plan.”
2. A firm understanding of risk
Hedging is designed to protect an organization against financial risk, but no strategy is foolproof.
Some hedging programs can incur high administrative and automation costs. Some strategies, especially those that depend heavily on speculation, will inherently expose an organization to more risk, including the potential for an adverse event.
A solid risk management strategy can help offset potential losses. Leveraging their own resources and knowledgeable partners, enterprise leaders should examine their risk tolerance and move forward with a clear-eyed awareness of what they’re taking on.
“When a company is essentially forecasting transactions that they have underlying exposures with and something fundamentally changes from those underlying assumptions,” Renta says, “it means a company has to find a financial partner that can both understand the underlying drivers for why those changes are taking place and employ strategies that […] actually marry up with what their underlying exposures look like, post the disruption.”
3. Regular review
Hedging is designed to help organizations better cope with currency fluctuations, so as global conditions change, hedging strategies should be reviewed and adapted to ensure adherence to long- and short-term goals and changing business needs.
“The key takeaway is when you’re working internationally, you need to partner with someone who understands the market dynamics and can offer you the flexibility to ensure that your hedges and your underlying exposures are measured,” Renta says.
How to develop and manage a hedging strategy
In developing, implementing and managing a hedging strategy, organizations should consider their short-term goals alongside their long-term business needs.
Hedging strategies typically involve a few key moving parts.
Consider the hedging lifecycle
The FX hedging lifecycle involves various stages, from planning to execution to review.
Traditionally, an FX hedging strategy starts with a planning phase. This is the time to calculate a risk value and whether this value can change depending on external conditions (such as a political or economic upheaval).
Once everything is planned out and risks are managed, it’s time for the next stage. With a well-thought-out strategy and clear objectives, executing the trades is meant to be the easiest step.
Reviewing what worked well and optimizing for potential misses is the final phase, before the FX hedging lifecycle repeats.
Identify specific vulnerabilities
These might include transactional exposures (cash flow); translation exposure through balance sheet items like foreign cash balance, inventory, fixed-rate loans or bonds; net equity in foreign subsidiaries; firm commitments; and your net investment exposure, all of which are tied to an underlying asset.
Depending on the balance of business holdings and particular investments, organizations should be able to identify their big-picture vulnerabilities as well as individual touch-points that need attention.
Then, regulatory complexity and lack of consistency across different markets pose significant challenges, a task even more difficult without a knowledgeable partner.
“It’s a complex [undertaking] that requires horizon scanning and a true army of people to make sure that you’ve got proper subject matter expertise to ensure that you’re doing what you’re supposed to be doing as it relates to each of the regulatory regimes where you operate,” Renta explains.
Account for key stakeholders and communication needs
Hedging programs can impact a variety of stakeholders in an organization, including accounting departments, legal teams, technical staff, financial planning teams and more.
Ensuring that all stakeholders understand the goals and expectations of the FX hedging program and receive consistent, clear communication as it evolves is essential to the success of a hedging program, especially when using complex financial tools like options and futures contracts.
Weigh the costs
Hedging can incur significant costs, from additional administrative fees to lower-than-expected portfolio growth over the long term.
An organization should consider costs and risks alongside any potential benefits of a hedging program.
The timeless key to a successful FX hedging strategy
Like any major financial decision, whether or not an organization decides to implement a hedging strategy to protect against currency risk, and how to implement that program, will come down to a complex set of considerations based on its individual goals, needs and risk tolerance.
A solid awareness of risk, clearly defined goals and a well-thought-out plan are the first steps to building a hedging program that can maintain an organization’s financial health in times of uncertainty and offer essential portfolio protection.
Partners, like Convera, can help develop, implement and manage an effective hedging program. Starting with a suitability assessment, Convera’s hedging experts consider financial knowledge and experience, financial conditions, risk tolerance and goals and objectives for each client. Convera then helps you tailor a hedging portfolio based on what you’re looking to achieve and what’s really suitable for you based on your financial markets experience and where you’re hoping to get to.
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