In our last blog, we discussed the tools you can deploy to manage your exposure to currency risk when making overseas payments – from spot contracts to structured products.
In this blog, we will illuminate some currency strategies that businesses use in tandem with the products we previously described to hedge their requirements. Hedging is a methodology that seeks to remove – in part or in full – the impact of currency market movements on the cost of sending money overseas.
Unless you’re a financial institution that’s speculating currency to achieve high returns – that’s the excess return on an investment after adjusting for market-related volatility and random fluctuations – you should consider a hedging strategy to mitigate the inherent currency market risk and provide some certainty when paying invoices, costing or budgeting. It is not uncommon for certain currency pairs to experience a 10%+ range between their high and low points during a 12-month period. These market movements are out of your control, so you may want to consider how you can mitigate the uncertainty associated with ever-changing interbank rates.
Hedging can be as simple or as complex as your business wants it to be. The aim is to avoid losing money because of currency fluctuations by gaining control over your international payments. These strategies can help you do just that, turning your overseas payment ambitions into achievements.
Set and Forget
Overview
This involves covering off each currency exposure for a future date with a hedging contract (forward or structured products), thus achieving certainty in the exchange rate versus the costing you have forecasted. This allows you to forget about future currency market volatility and concentrate on your day-to-day business needs.
Benefits
- Removes currency volatility at inception.
- Saves time and ambiguity as it provides a simple mandate.
Considerations
- Your overseas payments provider will need to provide you with a credit line to offer the hedge. They may require some form of cash to be posted during the life of the hedge if the currency market moves against your hedged position
- This strategy may be restrictive if end-user price flexibility is required or your competition can adjust their pricing.
Partial Cover
Overview
This involves covering off a proportion of your foreign currency exposure for a future date or period with a hedging contract (forward or structured products). While this does not remove the risk in full, it does proportionally.
Benefits
- Reduces currency volatility at inception for part of the requirement
- Saves time and ambiguity as it provides a simple mandate.
Considerations
- Provides an element of certainty – currency moves could still impact you both favourably and unfavourably for the uncovered element of your requirements
- If the currency market moves against your hedged position, you could be subject to a margin call which might impact working capital.
Layering
Overview
A layering strategy is a systematic approach to currency management that removes part of the emotion from decision-making. This involves buying multiple tranches of your currency requirement using hedging instruments for different maturity dates – a process that is repeated at a defined time. The aggregation of the multiple trades booked throughout the period acts to smooth the currency volatility for the duration of the exposure.
Benefits
- Systematic approach removes emotional decision-making
- Acts to smooth currency volatility
- Ability to be flexible with market conditions.
Consideration
- The business requires a clear line of sight of its currency requirements
- More complicated than “Set and Forget” so may require internal discussions.
Portfolio Approach
Overview
A portfolio approach to hedging generally involves multiple product classes such as spot, forwards and structured products combined in a manner that fits the company’s hedging mandate. An example is a 40/40/20 model – 40% structured products, 40% forwards and 20% spot.
Benefits
- Provides a level of protection on a company’s currency risk exposure
- Provides the ability to be flexible with product selection
- Provides the ability to benefit from advantageous moves on a proportion of the business’s currency.
Considerations
- As a portfolio approach may involve structured products, this could result in your final exchange rate not being known until these products expire
- Decision-making on product selection is time sensitive
- Understanding of a wider range of products is required and their potential impact.
This only scratches the surface of the strategies you could deploy as part of your currency risk management. It is not a case of one size fits all, meaning a bespoke approach is required; one that aligns with your business in terms of time management, customer base and the impact of currency movements.
In our next blog, we will explore some of the tools available to facilitate informed decision-making around currency management.
This blog post is intended to provide you with information on the services Lumon Pay Ltd (“LPL”) offer and should not be interpreted as advice or as a solicitation to offer to buy or sell any currency or as a recommendation to trade. Foreign exchange rates provided therein are for indicative purposes only and are not intended to give an accurate reflection of current currency exchange rates or to predict future movements in currency exchange rates. LPL, trading as Lumon, is a company registered in England with its registered address at Building 1, Chalfont Park, Gerrards Cross, Buckinghamshire SL9 0BG. LPL is authorised by the Financial Conduct Authority as an Electronic Money Institution (FRN: 902022).