Foreign Exchange | Articles
How foreign exchange risk works
To Hedge or not to Hedge? The Pros and Cons of Foreign Exchange Risk Management
For every article lauding the benefits of currency hedging, there are just as many that criticize the practice. The multitude of opinions on foreign exchange risk management is often driven by the increasing number of businesses that regularly conduct international transactions. Even small and newer companies maintain a level of foreign exchange rate risk through common activities like buying overseas supplies, selling products in another country and outsourcing tasks to foreign staff. Generally, anyone who makes non-local payments can be vulnerable to shifts in currency exchange rates. Despite owing a set amount each month to an international partner, the actual cost can fluctuate and depending on the severity, can affect a business’s bottom line.
What is Currency Risk?
Currency risk or hedging refers to the unpredictable nature of exchange rates between two different currencies. The aim of hedging is to manage the risk of exposure, or financial loss, when the exchange rate fluctuates unfavourably. Businesses can opt for a set exchange rate in order to help avoid volatility and accurately manage profits.
The Argument Against Hedging
While the goal of hedging is protection, not everyone is a fan. Businesses with irregular or small international payments may not necessarily be a candidate for the practice. Additionally, some market watchers fear missing out on a better spot rate, should they commit to a fixed one. While it’s true that some months a spot rate may be more favourable, there may also be months where having a fixed rate can save the business from taking a financial hit.
The Benefits of Hedging
Protecting profit margins is often a key goal for companies. One advantage of hedging is security: a CFO can accurately plan a fiscal budget and the pricing of products and services can be maintained, as the cost would be static. Foreign exchange rates can be unpredictable and even traditionally stable currencies can be susceptible to movement based on market events or unforeseen circumstances.
Misconceptions about Currency Hedging
- Speculation: While hedging is a risk management strategy, some actually consider the practice a form of speculation. Opponents argue that deciding on a fixed exchange rate is itself a gamble as the forex market is unpredictable and choosing to hedge does not guarantee the most favourable rate. While it’s true that hedging may not secure the most optimal rate, primary objectives are to allow predictability and manage unexpected losses.
- Unnecessary in times of low volatility: There are periods in the market where major currencies are relatively stable and do not experience steep dips and rises for months at a time. During these cycles, critics of hedging often suggest that its pointless to bother hedging. However, it’s important to note that these phases rarely seem to last. It’s nearly impossible to predict shifts in the forex market and businesses with concerns about their exposure may be better off hedging from the start, rather than waiting until after an unfavourable move.
- Flexible pricing: Some companies choose to adjust the pricing of their goods and services based on the shift in currency. While a number of businesses have this freedom, an unexpected dip could mean that customers may be subject to an increase in cost, which could lead them to turn to a competitor.