FX Hedging: Is Your Strategy Still Fit For Purpose?

Managing currency-related risks is a growing concern for many corporates, given significant foreign exchange (FX) volatility. Nevertheless, an optimal hedging strategy should always be tailored around the business, rather than the market, says Toni Rami, Co-founder and Chief Growth Officer, Kantox. Here, he explains how treasurers can implement a dynamic FX risk management strategy, automate FX-related workflows, and gain a competitive edge – even in the most challenging of operating environments.

As the Covid-19 pandemic has impacted global financial markets, many organisations have seen drastic changes in their business flows, relative to forecasts, and discovered failings in their FX risk management strategies. The importance of implementing an efficient and tailored FX hedging programme has never been clearer – it can mean the difference between profit, loss, and even bankruptcy.

Rami explains: “Covid-19 caught the world off-guard. Treasurers and CFOs suddenly found themselves working from home, battling the most significant market turbulence since the global financial crisis of 2007/8, and trying to gain visibility over their FX exposures and hedges. Companies without a streamlined FX workflow in place were scrambling to pull data together remotely, often from different systems.”

Alongside the headache of achieving visibility in such a manual way, many decision-makers have been left questioning the accuracy, timeliness and reliability of the data received, says Rami. “Often, it is unclear what is a forecast and what is committed – this is a common complaint among treasury professionals, even in a typical working environment. This lack of clarity, combined with the deviations from forecasts, means that over-hedging is becoming a very real risk.”

Reflecting the business

In such uncertain times, it is understandable that firms are being cautious but over-hedging is symptomatic of a hedging strategy that is reactive, rather than proactive, Rami believes. “The Covid-19 crisis has exposed the weaknesses of FX policies that are tailored around the market, rather than the business. An optimal hedging strategy must be in sync with the way in which the business operates and how profits are generated.” This is even more critical in an environment where business models are rapidly evolving.

“The global lockdown has accelerated the growth of e-commerce. Organisations are switching to digital business models, or upgrading and expanding their existing digital offerings,” he notes. As a result, cross-border opportunities to conquer new markets are opening up and market share is being reshuffled as digitally enabled competitors enter the ring.

“The importance of having a flexible FX strategy, which is aligned with the business and the dynamics of the digital distribution channel, cannot be underestimated when conducting international e-commerce,” cautions Rami. For example, selling the same product online in different currencies means that there might be an arbitrage opportunity for savvy shoppers. Pricing strategies therefore need to be carefully monitored and adjusted where necessary, and hedging programmes must be flexible enough to shift accordingly.

Seeking home advantage

“The right hedging strategy can also create a competitive advantage for companies operating across borders by ‘removing’ the responsibility for managing FX risk from buyers and suppliers,” says Rami. “If, for instance, your company buys raw materials from China in euros, the Chinese supplier will factor the currency conversion into the price – and likely look to increase their margin in the process. By buying the raw materials in Chinese yuan, rather than euros, you take responsibility for the FX risk – and can seek to achieve a better price and improved margin.”

The same goes for buyers too – in particular those in geographies such as Russia, Brazil or Turkey. “If a client from one of these countries pays in US dollars, they might delay making an order because they are waiting for the exchange rate to be more advantageous. But if you sell to them in their local currency instead, and make the transaction FX neutral for them, orders may come in more quickly, and with greater regularity, as the buyer has certainty and visibility over pricing.”

If buying and selling in local currencies seems like a significant leap, there are ways to minimise the risk. “Take micro-hedging, for example. This involves hedging each transaction as it occurs, regardless of the underlying value of the receivable or payable. Micro-hedging enables corporates to protect expected foreign currency cash flows from exchange rate volatility, locking in margins and improving forecasts in the process. In essence, this is a real-time hedging strategy that gives corporates peace of mind when buying or selling in currencies other than their functional currency,” Rami notes.

Mining for sector secrets

Targeted industry insight can also assist in building an optimal FX hedging strategy, Rami believes. “By working with the dynamics of the industry, it is possible to create a competitive advantage through proper management of FX risk.” He cites the meat industry as an example.

“Traditionally, meat producers have sold the majority of their goods close to home, but in the past year or so, a trend has emerged for international meat sales. Producers have discovered that certain parts of animals, such as offal, are more popular in markets such as China, Hong Kong, and Brazil, than in Western markets. The producers offering the most competitive prices in these new markets – by selling in local currency – are the ones making the biggest gains.”

Sectors such as travel will also be reliant on extremely competitive pricing in order to re-establish growth as the economy rebounds. “There are two business models in the travel sector: the catalogue model where the client pays a fixed price for a package holiday via a tour operator; and the dynamic packaging model whereby individual elements of the holiday are sold separately and priced live at the time of purchase.”

The catalogue model involves significant risk, and profit is based on large volumes. “As such, dynamic packaging is likely to rebound first as the risk to the operator is much smaller. However, consumers will be looking for excellent deals post-pandemic, so pricing will need to be aggressive – which makes having the right FX strategy even more important for tour operators.”

Of course, hedging strategies are not ‘one-size-fits-all’. “What works for one company in one sector cannot always be applied with the same results in another – but having these additional insights can make a big difference to the efficiency of the hedging strategy,” Rami believes.

Information from automation

Another way to gain valuable insights into FX risks, and grasp how to mitigate them more effectively, is through automation. This, says Rami, involves examining the scope for automation within the company’s FX workflows, and analysing the incremental efficiencies that automation can bring to a company.

He adds that the benefits of automation are reflected in three dimensions: cost, risk, and growth. “Cost largely revolves around financial optimisation. This is not just about removing manual processes, but also about reviewing workflows and improving them to suit the way the business works. For example, it could be more time-efficient to hedge sales orders once a day rather than once a month, thus enabling the team to be more agile and capitalise on opportunities elsewhere.”

Risk, meanwhile, comes in many forms when FX workflows are manual. “Human error is rife – mistakes in Excel formulae can be very costly,” Rami cautions. “Manual processes also leave doors open for fraudsters, since there is limited security in place. Again, a breach can be very expensive and essentially increase the cost of hedging, due to insecure processes. Automation addresses these challenges and ensures the FX workflow is secure and compliant, while minimising the risk of error thanks to STP.”

As for growth, the benefits present themselves in the form of removing risks, and therefore costs, from FX risk management. “In companies with manual processes, products are often marked up to offset sub-optimal risk management processes – making the company less competitive.” Human resources are also tied up in manual work, preventing them from being more strategic. “Sales, for example, might only want to sell products priced in euro or dollar because they do not have time to manage additional currencies. An automated FX programme can remove these growth limitations and enable the company to operate to its true potential.”

In short, many of the biggest FX challenges can be solved by automation. And as the economy starts to recover, automation of FX workflows will play a key role in enabling corporates to price their products more competitively, and take advantage of opportunities in new markets – whether through physical or digital operations.

It is important to remember, however, that none of the above can be achieved without a sound FX policy in place. “One of the biggest mistakes companies make is having an FX policy that is too high level. The devil is in the detail and it is important for companies to take the time to step back and scrutinise their current FX policy. They may find more inconsistencies than they imagine – and this can leave them making decisions in the dark,” Rami warns.

Another common pitfall, he says, is using budget rates in the policy instead of pricing rates – keeping too much focus on the market, rather than the business. “This is an outdated way of thinking, and as I explained earlier, this can be detrimental to growth.” An additional old-fashioned approach is the habit of measuring the effectiveness of the FX policy by the exchange rate losses it generates.”Often the same ‘big picture’ can be perceived differently by the finance and commercial teams, and there needs to be a more coherent approach to reporting and measurement across departments”.  With the right tools in place, performance can be traced down to the minimal expression of exposure, providing real-time situation reporting.”

Crisis catalyst

Taking all of this into account, there is clearly work for CFOs and treasurers to do around revisiting the FX policy and explaining proposed changes to the board. “The pandemic has provided an excellent opportunity for an honest reassessment of how coherent FX risk management policy and processes are,” says Rami. He advises that any revamped policy should ideally be detail-rich, describing every step of the FX workflow, as opposed to improvised and decided on the spot. It should also be flexible enough to optimise financial variables once risk goals are set, i.e. always considering FX risk beforehand.

He adds: “When conducting this kind of review, it is important to remember that an optimal hedging strategy should be: tailored around the business, not around the market; automated, as opposed to manual; and designed to create a competitive advantage with currencies by removing FX risk from clients and suppliers.”

In summary, today’s treasurers and CFOs have a unique opportunity to do away with outdated practices and policies holding back their management of FX risk. “Boards are looking for efficiencies and are open to new ideas. They are also seeking growth opportunities in international markets. By rethinking the company’s approach to FX risk management, the treasurer can demonstrate their strategic value to the organisation, while delivering tangible benefits in terms of cost, risk and growth.”