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How to implement a currency hedging strategy in 4 steps

24 May 2022

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Do you operate internationally and carry out transactions in foreign currencies? Do you want to protect your margin from daily exchange rate fluctuations? Here are 4 simple steps to understand how to hedge currency risk and effectively protect your company from daily foreign exchange risk (without ever falling into speculation).

 

1. Analyze your exposure to foreign exchange risk

Directly or indirectly, every company is nowadays exposed to currency risk on the foreign exchange market. However, this does not mean that all companies are in the same boat. Not all situations require the implementation of a hedging strategy as every company has its own currency risk management strategy. A company with a one-time exposure to a foreign currency transaction of a modest amount will not handle currency risk the same way a company with an international presence whose commercial margins depend directly on the foreign exchange market will. The first step is to carefully analyze your exposure to foreign exchange risk.

To do this, start with a risk analysis. List your assets in foreign currencies (receivables, bank accounts, financial investments, etc.) and your debts in foreign currencies (accounts payable, loans, etc.) in order to evaluate your exposure to foreign exchange risk.

You should also anticipate the evolution of your foreign currency cash in-flow and cash out-flow throughout the year. A budget forecast is your best tool to measure your exposure to risk. By preparing an accurate budget forecast, you will be able to identify more subtle foreign exchange risk exposures (you will need to analyze the pricing structure of your products and/or services). This will allow you to define a "budget rate", i.e., a weighted average exchange rate at which you plan to convert your currencies during the year.


2. Choose the currency hedging strategy that fits your company's needs

Once the audit phase is over and the various foreign exchange risk exposures are clearly identified, you will have all the elements in hand to define your foreign exchange policy.

You will then be able to choose between several different approaches depending on your commercial margins, the cost of hedging financial products and your degree of risk aversion:

    • if you want to immediately lock in the exchange rate of your foreign currency transactions, systematic risk hedging will be the most suitable for you;
    •  If, on the other hand, you are only looking to lock in the exchange rates of a portion of your transactions, then selective risk hedging will be more suitable for you.

Remember
Many of your foreign exchange exposures can offset each other to provide a "natural hedge". Whenever possible, it is important to hedge only your net exposure to avoid unnecessary expenses and the risk of "over-hedging".


3. Identify the coverage products best suited to your situation

Within the framework of a hedging strategy, there are many more or less exotic financial products available to secure exchange rates.

This is why you must be particularly vigilant about the quality of the hedging products offered and make sure you understand how they work and the related costs before making any decision, at the risk of ending up with a financial product that does not suit your needs.

Make derivative financial products such as forwards, flexible forwards and dynamic forwards, your first choice. In most cases they will prove to be the most suitable for your company's needs.

Your choice will depend on a few key factors: your risk appetite, your available cash flow, your price budget, but also your exchange rate policy. For example, a company wishing to lock in its exchange rate will prefer traditional forward contracts. On the other hand, a company that wants to leave itself more leeway will tend to use flexible or dynamic forward contracts. Talk to an expert to make sure you understand how these products work and their compatibility with your individual situation before making a commitment.

 

4. Always keep an eye on your risk exposure and reassess your strategy if necessary

Your business will change and grow from day to day, and exchange rates are constantly changing. That's why it's important to regularly monitor your risk exposure, to keep an eye on your weighted average realized exchange rate (and compare it to your "budget rate"), and to assess all exchange rate gains and losses.

When analyzing the results of your hedging strategy, always keep in mind that your goal as a good manager is to protect the financial health of your company by trying to cushion the currency fluctuations of the market, not to maximize your gains. This is why you should focus on the stability of your trading margins guaranteed by your hedge and not on the foreign exchange gains made.

 

In short, the 4 main steps of a good hedging strategy are simple: take stock of your international financial situation, choose the strategy best adapted to your company and identify the corresponding financial products, and finally monitor your strategy in order to modify it if necessary.

Find out which hedging strategies can improve your currency risk management by taking contacting our experts!

 

 

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