There are various tools to manage currency risk: swaps, options etc. They provide compensation for currency movements. A simple hedge method is a forward swap. You agree to buy a fixed amount of a foreign currency at a future date and at a known exchange rate. You may win or lose on this deal; your gain or loss is offset by the transaction you are hedging. A perfect swap hedge is one where the date and value of the transaction occurs exactly as forecast. In this case the swap completely takes away the currency risk (less the cost of setting up the deal). It sounds good. But it may not be the right choice. Hedging reduces the effects of risk, which means less downside and less upside. However, risk is the way businesses make profit.
Real-world currency management
Contact us if you want to improve your currency management. With years of global trade experience in Asia and Europe, we have deep experience.
We'll show you tools to discover the extent of your natural hedging, ideas for turning your currency exposure to your advantage, and we'll audit how well your systems are reporting and controlling exchange rate effects.
A note: forward-swap hedging means buying currency against known or forecast future needs. It doesn't mean buying USD because the rate looks good. That's speculation. Hedging requires firm future transactions, or good cashflow forecasts based on goods-movement forecasts. A sound hedging policy is mechanical: each month as the forecast is revised, hedges are automatically placed and revised regardless of exchange rates. Since future periods are harder to forecast, perhaps only 50% of future demand is hedged, firming to higher percentages for the near future.
The two key questions about hedging a risk
The first key question: is this risk something you can manage or exploit through decision making? In terms of currency risk, this may include your ability to source in different currencies. Perhaps you have good demand forecasts.
The second key question is: can you manage the risk better than competitors? (are you faster at reconfiguring your sourcing? Are you better and faster at demand forecasting?)
This combination of being able to influence or manage the risk , and being able to do it better than competitors, indicates you have a competitive advantage. Tim Cook of Apple shows that supply chain management is a powerful source of competitive advantage.
If the answers are yes, you may be foolish to throw away an advantage by hedging your currency risk.
To make money, you need to take risks that give you the opportunity to outperform competition
Risk is how businesses make money. A retailer owns stock; that's a potential risk because it may become obsolete, requiring price reductions.
The more risk, the more profit: a fundamental market truth. But this is only true for risk that falls within the expertise of management: risks that management can manage better than competition. A good retailer knows its customers, so when decisions are made to buy stock, they are made with expert judgement. So buying stock and facing the risk of obsolescence is the correct decision. A good retailer will make better decisions than competitors, and will profit from its knowledge of the market. However, the same retailer doesn't know much about quickly repairing a warehouse destroyed by fire. Rather than mastering this skill, it's more sensible to take out insurance policies covering fire damage and business interruption.
The key question about risk is simple: is the risk something you think you can manage better than competitors? Is the leverage of this risk big enough to be interesting? If the answers are yes, you shoud see the risk as an opportunity to make profit ( 'add value'). If the answer is no, then you want to perform at average levels, probably by paying for an external party to manage the risk.
Where do your currency risks fall? Are they linked to your expert judgement, or are they something you want to protect against, even if it costs you and removes potential benefits?
The answer is not obvious.
A case study: currency risk for a trader
Let's assume you are a retailer, buying consumer electronics which are made in China. Currently you buy from an Australian distributor, in AUD, but you want to change, to buy directly from a Chinese agent, in USD. Ignoring the currency risks, this decision increases your risk in these areas:
- supply chain management
- cashflow and inventory forecasting
- customer service and warranty
Buying direct from China is a lot cheaper, but you need to master supply chain skills: you need to import and clear customs, pay insurance on the boat, use a competitive freight forwarder and manage more complex sales forecasts, because stock takes six weeks to arrive. You also need to take control of warranty and returns. Most likely, you will decide to take this approach:
- the supply chain management risk is too hard to master, so you'll trade away some price advantage to get a full-service freight forwarder.
- The customer service and warranty issues are customer-based and are a chance to build your brand and customer engagement, so you take on these new operational requirements.
Now let's turn to the currency risk.
Against appearances, currency risk is a business risk, not a financial event
Currency risk appears to be about currency markets. Even specialists can't accurately predict the movements of currencies , so how can it be possible for a retailer, manufacturer or trader to outperform competition by taking on currency risks?
The answer lies in what the currency risk really is.
In our case study, imagine the AUD strengthens quickly (and surprisingly). Then imported Chinese products cost less. If you were about to place an order for stock from China, you will get a price advantage over competitors who have stock that's left China before the AUD surged higher. Other competitors who are still buying from the Australian distributor need to wait until the distributor decides to pass on savings. In this case, you're lucky with timing. You win. But you could have equally lost, if the currency had suddenly moved the other way.
Can you do better than luck? Possibly. The less stock you keep, the faster you can respond to changes. You may decide to turn a six week shipment time to four days by using air freight.
Also, perhaps the assumption that China is the only source is wrong. What if equivalent products could be sourced from India? A business which can quickly pivot to suppliers in a different country has another tool to take advantage of exchange rate movements. Supply chain flexibility and stock management are two ways that the retailer can outperform competition and turn exchange rate movements to advantage. If you decide that you can outperform competition like this, then hedging exchange rate movements is blunting the sharp edge of your competitive advantage
(Note that hedging Chinese purchases can be tricky. Chinese suppliers often prefer to be paid in USD, and invoice in USD. It appears that your exchange rate risk is AUD/USD. However, many Chinese supply contracts specify a CNY/USD rate because local currency is often an important expense. If the CNY/USD rate moves beyond the contract threshold, they have the right to reprice. So the real risk is AUD/CNY, and that's difficult to hedge against at the time of writing).
How GrowthPath can help
This article talks about understanding your competitive advantages, and not throwing them away with hedging. It also specifically talks about currency risk management. GrowthPath is experienced at helping medium sized business identify, focus and measure their competitive advantages.
We are also unusually experienced with foreign currency flows, having worked for years in firms importing and exporting globally. Tim was in Indonesia in the late 1990s when the local currency devalued by 17000%, and both Tim and Alan had industrial responsibilities in Europe with factories facing Chinese competition and sourcing globally. They can help you see your real (net) currency flows and risks, help you forecast better by seeing the effects of currency movements across very complicated currency flows, and help you understand if you should own your currency risk, or insure against it.