Hedging Currency

In my March 17, 2011 post I discussed foreign exchange. Today I want to expand upon the concept called hedging.

If you agree to pay in another currencies there are basic three options available:
1. You need your company to generate those funds from sales into that country where payment is in the local currency. Funds generated in this manner provide what is called “a natural hedge” against currency exchange changes as you already have that currency available for your use.
2. You can purchase the funds in advance from the financial marketplace in what is called a "hedge contract". The cost to buy foreign funds for future delivery is called the forward rate. Forward rates are published in financial papers and internet financial sites.
3. You can pay by exchanging currency at the date needed to payment. This type of a purchase is called a “spot purchase”.

For those companies which don't have a natural hedge, or where the natural hedge isn't sufficient to cover all the local expenses and purchases, and you jave agreed to pay in local currency, it's necessary for buyers to consider whether to let the exchange rate "float" (make a spot purchase) or purchase a “hedge contracts”.
The forward exchange rates are established based upon market factors such as: the available supply and demand, the timing of the purchase, the risk or volatility with both currencies, and the currency changes that currency traders predict.

Hedge contracts are expressed as dates in the future and are called forward rates. You can have 30, 60, 90, or 120 day forward rates, etc. A hedge contract is a commitment today for the buyer to purchase and the seller to sell the agreed amount of currency agreed at the agreed price at that agreed time increment in the future.

The decision of the buyer on whether to hedge then becomes:
1) Is there any perceived currency risk to be managed?
2) If there is risk, do I let the rate float or do I hedge?
3) If I hedge, how much do I hedge through a forward rate?
4) If I hedge, when do I hedge and for what forward rate periods?

The decision on hedging also ties closely to the accuracy of forecasts. If Buyer’s trading currency is strengthening versus supplier’s currency and you buy less than, equal to or greater than the amount forecasted the hedge provides no value, only a cost Where forecasts are important is if your trading currency is weakening versus the supplier’s currency. If actual purchases are less than forecasted, you get the benefit on the purchases made, but you also incurred the cost on purchases not made. If the actual purchases are more than forecast you get a win from hedge that protected the forecasted amount, but that benefit will be offset by the incremental cost to purchase funds the addition funds needed at the then current spot rate. It is only when the actual purchases are as forecasted that you get the maximum value for purchasing the hedge contract.

The shorter the window between purchase commitment and payment, there is usually less of a risk as long as the financial markets are stable. The best price is usually in the local currency of the supplier as it takes most currency exchange concerns out of the supplier’s pricing. Forcing U.S. dollar denomination pricing will cause the currency risk to be shifted to the supplier, and the supplier will build in contingencies. You should only agree to pay in the supplier’s preferred currency when that leads to cost savings or when your company has natural currency hedge at no additional cost. If you don’t have the skills, always pay in your currency and if you must pay in foreign currency always involve your company’s Treasury department or their expert in foreign exchange or hedging decisions.

One final comment. Frequently buyer’s may seek to avoid currency exchange issues by paying in their preferred currency using what is called a band width contract. In a band width contract the price is fixed in the Buyer’s currency as long as the currency exchange rate stays within agreed band that has upper and lower limits.
Band width contracts favor suppliers. At the worst point in the band for the Supplier they will still make money. At the best point in the band for the supplier they will make even more money. If the rate goes below their worst point they either don’t have to sell or they can re-price based on the change. If the rate goes above their best point, the buyer can re-negotiate, but what they are re-negotiating against was position that was already the best for the supplier.

Let me show you an example. Today’s exchange rate between the U.S. Dollar and Japanese Yen is 76.745, meaning one dollar is equal to that amount of yen. The Japanese supplier has a product that costs ¥7674.50, which equals US$100.00. You agree that the price will be US$100 as long as the exchange rate is between ¥70 and ¥82. The best rate for the supplier will be at ¥82 as the Dollar will buy more Yen. The worst rate for the supplier is ¥70 as it purchases less Yen. In agreeing to the band the supplier knows that they will be profitable even at ¥70. They will be even more profitable at ¥82. If the rate goes below ¥70, they either don’t need to sell or they can re-price so they never lose. If the rate goes above ¥82 the buyer can re-negotiate, but that re-negotiation is against their already best price of ¥82.