Hedging: Managing international foreign currency risks

Financial risks Hedging foreign currency

Neither shareholders nor CEOs like negative earnings surprises - especially if they seriously worsen the company's results. Not infrequently, however, such surprises arise in connection with high foreign currency fluctuations. In the last two years, we have experienced this in the EUR/USD currency pair, for example. 

Hedging makes foreign currency risks controllable

The good news is that even for medium-sized companies without their own treasury department, the risk is manageable. What exactly is at stake? 

For companies in the euro area, foreign currency risk generally arises when a relevant volume of goods is bought or sold in foreign currencies without a corresponding offsetting item in the same currency and in the same period. Incoming invoices in the relevant foreign currency can, for example, serve as an offsetting item. This is referred to as "natural hedging". 

Exchange rate fluctuations

Another decisive influencing factor is the extent the exchange rate fluctuation, known as volatility. For example in times of war or pandemics, the volatility of foreign currency exchange rates is particularly high.  

Source: Statista

Thus one received in the December 2020 for one euro still 1,22 US Dollar, in October 2022 it were then only 0.98 US Dollar. So around 20% less. 

In such cases, it may be necessary for the respective company be extremely rewarding to develop and implement a foreign currency hedging strategy.  

We call this "Fx-hedging" in the following (Fx stands for Foreign Exchange).  

Example: Negative effect instead of margin

Let us assume that a German mechanical engineering company A has received an order for a machine worth USD 10 million from the USA in September 2022. The exchange rate at that time was 0.98 EUR/USD. The order is extensively celebrated by all employees, as it is a large order for A and promises a good margin. Delivery and invoicing are scheduled for March 2023. There is therefore enough time to manufacture the machine to quality standards and deliver it on time. As usual, the American customer insists on invoicing in USD. 

Although Company A will not have any USD incoming invoices in the same period, the CFO decides not to hedge the business against currency fluctuations when he receives the order in September 2022. He assumes that the EUR/USD exchange rate will remain close to parity for the six months until delivery. As a result, he places the transaction at €10 million in his financial plan for Q1/2023 as of Sept. 30, 2022. In the meantime, the purchasing department is starting to procure the parts from the bill of materials for the machine. 

Lack of protection

The company will deliver the machine on schedule on March 31, 2023. The exchange rate at this time is 1.07 EUR/USD. Company A receives only €9.35 million instead of the planned €10 million due to the rise of the euro against the dollar.  

The negative effect for Company A thus amounts to EUR 650 thousand in just six months. This negative effect has a full impact on earnings and is therefore extremely painful for Company A. There is nothing left of the previously planned good margin. 

Smaller SMEs in the mechanical engineering and capital goods industries can be particularly hard hit if they fail to hedge such transactions, especially in the current highly volatile environment.  

Foreign currency risks in the company

In addition to exports, there are numerous other causes from which a significant foreign currency risk can arise, e.g. purchasing in foreign currencies (e.g. in China, India or the USA), or paying employees:inside abroad. The repatriation of foreign sales or financing in foreign currencies at a point in the future can also lead to significant foreign currency risks. 

So how can medium-sized companies counter this risk with relatively little financial and personnel effort? 

Generally, companies that have material foreign currency sales should first develop a good understanding of their corresponding foreign currency exposure and use this to create an appropriate fx hedging strategy.  This consists of the following steps: 

Analysis of foreign currency risks
  • What is the proportion of your business that results in foreign exchange payments? The higher this proportion, the greater your likely risk. 
  • Which countries do you do business with? In some countries, the political instability is much greater and the volatility of currencies is therefore probably higher. 
  • How often do you make payments? The more frequently you transact, the more you will be exposed to exchange rate fluctuations. 
  • Is there a simple process change that can eliminate or minimize exchange rate risk, such as aligning a customer's billing cycle with supplier payments? 
  • Can you invoice in your currency and eliminate the risk of exchange rate fluctuations? This shifts the currency risk to the local customer/supplier. 
  • Do you have business expenses where you have customers? Then you could use local currency accounts to pay taxes and suppliers in foreign currency and avoid unnecessary conversion fees. 
Fx hedging strategy
With the aim of minimizing negative effects on earnings due to currency fluctuations. How high this minimum level should or may be is determined by the company's so-called risk appetite. This should be clearly defined.

Gladly help our Expert:inside and partner at WB Risk Prevention Systems to help you create, implement and monitor a foreign currency hedging strategy to make your business more resilient. 

Feel free to contact us, we look forward to meeting you! 

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