Currency Hedging Strategies - Western Union GBP

October 2008 l US Version Foreign Exchange Risk Management: Protect Your Profits and Prosper in an Uncertain Economy Over the past few decades the growth and complexity of international business, multinational operations and import and export has increased at a staggering rate. As the economies of many different countries become more entwined, the economic stability and prosperity of the countries that you do business with becomes more important. This, coupled with the dramatic currency fluctuations that have taken place in developed and emerging economies, demonstrates the need to be aware of the factors influencing your business operations and the need to take an active role in protecting, stabilizing and potentially increasing your currency assets. Dealing with multiple currencies, foreign suppliers, imported goods or overseas operations exposes you to foreign currency risk. The key to surviving and thriving amidst ever-changing market conditions and currency fluctuations is to hedge these foreign currency risks that affect your business. A 2006 survey conducted by a large North American foreign exchange provider found that 80% of the corporations surveyed acknowledged that their businesses were exposed to significant foreign exchange risk. However, only 42% of these corporations indicated that they currently employ currency hedging techniques to manage their risk. Page 1 of 10 l Foreign Exchange Risk Management http://payments.westernunion.com

Top Three Myths About Currency Hedging Currency hedging is a common practice and essential to protect your business if you are involved in foreign economies or indirectly affected by the domestic economic performance within foreign nations. Yet there are still many misconceptions surrounding hedging. Myth #1: Currency hedging is speculative and risky. Currency hedging is a defined market that both dedicated foreign exchange companies and banks routinely deal in via specific over-the-counter products. Choosing which of those products to use and how to best employ them is determined solely by the party executing the hedge – your company. These decisions are carried out by a bank or dedicated foreign exchange provider under the explicit instruction of the client and according to previously defined parameters. The objective of currency hedging is not to maximize profits through currency speculation but rather to minimize the risk that your company is exposed to. A hedging strategy is The purpose of essentially an insurance policy against the adverse effects of currency fluctuations and currency hedging economic conditions that are out of your control. In the same way you would insure isn’t to generate your business from fire or theft, hedging insures your company’s currency assets from trading gains. unforeseen changes in the global foreign exchange market. The purpose should be to Currency hedging is an important component to your business planning to ensure that mitigate risk, not the success of your business is determined by its operations and not unpredictable increase it or economic factors and volatile currency rates. It acts as a stabilizing mechanism to swap one form of ensure that a company can project future cash flows - the valuation and reporting risk for another. requirement for most businesses - with better certainty. Currency hedging involves pro-actively taking measures to off-set uncertainty in international markets, exchange rates or a respective country’s economic strength. Also keep in mind that a currency hedging strategy is not the same as the various strategies employed by hedge funds, which are vehicles designed to take on market risk as opposed to mitigating it; you maintain control over the activities and degree of leverage and protection used. A strategy can involve making an informed decision to do nothing. It can also consist of partial or full protection, offering companies the ability to benefit from positive market changes while protecting them from negative ones. Myth #2: Currency hedging is only for the short term; in the long run exchange rates always average out. Some people believe that over the long term the gains and losses associated with exchange rates will average out and there is no need to protect your company against foreign currency fluctuations. This entirely depends on which currencies you are exposed to and what you consider long term to be. Such mean reversion theories Page 2 of 10 l Foreign Exchange Risk Management http://payments.westernunion.com

have lead to the downfall of many hedge funds and financial institutions in the current market environment. As the saying goes, markets can remain irrational longer than most speculators can remain solvent. Betting on long-term trends or reversion to historical averages can become very damaging when the markets shift dramatically in the short term, as they have in recent months. A long-term investor may take the viewpoint that a firm with revenues generated by foreign subsidiaries shouldn’t be hedged for translation purposes back to the parent company. Such an investor is primarily concerned with the operational profitability of each of the individual entities in their home currency, irrespective of what those net earnings are when translated back to the home currency. In such an environment there will be ups and downs: some years you will win and realize a windfall gain, while other years will result in a decline in earnings. In the long run however, the law of averages will hold and earnings will be smoothed over time. To an investor or manager with just such a view, a currency hedging system produces little or no value. That being said, a decision-maker with a long-term investment horizon will often lean towards implementing a hedge for one-time, non-recurring business expenses or projects with specific currency exposures. If the net present value or benefit of a particular project is put at risk through an unlikely but still probable adverse movement in currency values, the application of a currency hedge is certainly prudent. Even recurring business expenses that are core to the operational and financial performance of a firm should be hedged if the margin for profit and error are slim. If the viability of your entire business is put at risk should currency markets move unfavorably by a narrow margin for an entire business cycle or less, the implementation of a currency hedge should probably be a one-sided debate. Myth #3: I don’t need to hedge currency risk if I operate in US dollars and conduct foreign business in US dollars—I’m not exposed to other currencies. Even if you decide to pay suppliers in your domestic currency (i.e. US dollars) you are still exposed to currency risk through the ever-fluctuating currency rates and your international partner’s fluctuating economic strength. Currency risk affects companies that operate in multiple countries, companies that invest in operations abroad and companies that import or export their goods to other countries directly or indirectly through their suppliers. Even if you believe that you are not directly exposed to currencies outside of your domestic currency it’s likely that you are. Companies that don’t directly deal in foreign currency may be inadvertently impacted via suppliers if they deal in any foreign markets. For example, when you purchase from a supplier that imports from China, you are exposed to economic conditions in China, as your supplier will pass changes Page 3 of 10 l Foreign Exchange Risk Management http://payments.westernunion.com

in Chinese currency on to you. The Chinese economy has seen dramatic growth over the past decade, thereby forcing the yuan to continually appreciate against the US dollar. As such, when US dollars are used to import goods, their purchasing power is continually diminished. How To Manage Your Risks There are three things that a company can do when faced with the task of managing their foreign exchange risks. The first is to do nothing. If your international business relationships are strong and you think that any currency fluctuations will even out over time, doing nothing is an option. More often than not, however, it is a recipe for disaster. It is similar to purchasing a house and then failing to purchase house insurance to protect your investment. In the vast majority of cases, the acceptance of at least a moderate level of protection from currency risk is prudent. The second option is to alter your business practices and operations to manage the risk internally. This can be a very costly and time consuming task and it doesn’t always lead to better business efficiencies. The third and most effective technique is to partner with a provider that can help you manage risk through a currency hedging strategy. Hedging can be accomplished using financial derivatives to realize different goals based on the level of risk protection you’re seeking. Keep in mind that the types of tools and the extent to which you use them is entirely up to your company. What worked for The best ways to your company last year or last month may no longer be in line with changing market manage currency conditions and shareholder objectives. The strategies employed can be repeated, risk is to identify changed or abandoned as your company sees fit. You are not obligated to continue your company’s with a certain strategy if it no longer works for your company. FX risks and formulate a This is where an expert in foreign currency hedging can be invaluable. They can hedging strategy recommend a strategy and course of action based on your company’s specific goals to help mitigate and the level of risk you are seeking protection for. As your business grows, and as those risks. operations and market conditions change, an expert is there to constantly re-evaluate your position, level of protection and whether it is still in line with your corporate objectives. The Three Key Components Of Any Hedging Program Understand what you’re getting into and ensure that your hedging regime is aligned with your company’s overall goals. Ensuring that your hedge is appropriately positioned to manage risk and the expectations of organizational stakeholders is key. It is important to understand the downside risks to a financial transaction and the possible Page 4 of 10 l Foreign Exchange Risk Management http://payments.westernunion.com

ramifications created by the use of leverage. A hedging program should reduce risk as opposed to generate risk; only moderate uses of leverage with derivative products should be employed. Although there have been many widely publicized instances of large corporate failures involving derivatives, it is usually the excessive use of leverage that jeopardizes companies, not the derivative products themselves. As my grandfather used to tell me, a drink or two a day won’t kill you, but 10 a day will. The same theory goes for leverage. Regardless of the motivation for implementing a hedging regime, the core principles of a successful program will be the same across any organization. The purpose of a currency hedging program shouldn’t be to generate trading gains. The purpose should be to mitigate risk and not increase it or swap one form of risk for another. Many times over in my career I’ve seen companies lock in to what they believe is a favorable exchange rate with the expectation that the market will soon move in the A hedging opposite direction. They think that a hedge placed at a level they feel will be in-the- strategy should money will afford them a competitive cost advantage over their competitors. If the minimize the market moves in the other direction, however, they could very well find themselves with risks your an obligation that acts as an anchor on the competiveness of their business. If you find company is yourself in the situation where you think such a strategy may be prudent you should exposed to while ensure, at the very least, you enter into an optional hedge as opposed to a forward- ensuring that based obligation. the success of your business Ensure your hedge is placed at a level that provides break-even cost certainty is dependent on with room for a normal profit. Placing a hedge or worst-case exchange rate at a core business level that doesn’t allow your company to earn a normal profit is not a sustainable long- operations term strategy. The central motivation of a hedging strategy should be to reduce the risk rather than the that an adverse exchange rate movement poses. If you set your hedges such that they fluctuations in don’t truly protect the value of your enterprise, you’ve failed to mitigate this risk. the currency market. Companies can choose to devise a strategy to deal with these risks. This involves identifying where a company is exposed to currency risks, forming a policy to deal with those risks, defining the goals and strategies for mitigating those risks, and knowing how and when to act on or execute those strategies. Each company’s business operations and international exposure is unique. As such, it is important to create a strategy that is designed to accomplish different goals based on your company’s appetite for risk. If you already have a corporate hedging strategy and employ hedging mechanisms to protect your company it is important to re-evaluate your status and objectives on an Page 5 of 10 l Foreign Exchange Risk Management http://payments.westernunion.com

ongoing basis. This will ensure that the reasons you are hedging are still in line with corporate objectives, overall shareholder objectives and the company’s appetite for risk. 1 Identify Exposures 6 Evaluate Results & 2 Formulate Adjust Currency Risk Management The Foreign Exchange Policy 5 Execute Hedging Process Hedging Strategy 3 Determine Budget Rates 4 Formulate & Goals Hedging Strategy Finding The Right Products And Services For Your Needs The available vehicles and strategies in the marketplace for hedging range from simple to very complex and it is important to have at least a general understanding of what these products are. This allows you to more accurately instruct and communicate any necessary changes to your hedging provider. Forward Contract The forward contract is the most straightforward currency hedging tool available. It effectively allows you to buy or sell a foreign currency at today’s market price, while delaying the settlement of the contract to some future point in time. An adjustment, called the forward points, is applied to the spot price to compensate for the interest rate differential between the two currencies in question and the passage of time. Futures Contracts Similar to currency forward contracts, a currency future allows for the simultaneous purchase and sale of opposing currencies on a forward-dated basis. Currency futures are exchange traded and regulated products that trade in standardized amounts with four set expiry dates per calendar year. In addition, futures contracts trade in standardized amounts depending on the currency in question and are typically offset prior to, or at, expiry, with the most liquid contracts only being offered against the USD. Currency Overlay Strategy Money managers often deploy capital outside of their domestic economy as part of a sound investment diversification strategy. However, the decision to engage in an equity investment outside of one’s home currency inherently comes with the added Page 6 of 10 l Foreign Exchange Risk Management http://payments.westernunion.com

risk related to the translation of currencies into the foreign unit and back out again. A currency overlay strategy involves managing the currency exposure separately from the underlying asset. In addition to hedging the currency risk embedded within the decision to hold an existing asset, a currency overlay can also work if you’re expecting to make a future purchase in a foreign currency but are concerned that a short-term appreciation of the foreign currency will erode your purchasing power. FX Swaps An FX swap is the simultaneous purchase and resale of a foreign currency for different value dates. In most cases, the near leg of the transaction is dated for either same day, tomorrow or spot while the far leg of the trade is booked for a value date out into the future. Effectively, the difference between the rates for the two trades only amounts to the forward points between the two dates in question. Swaps can also be invaluable tools when it comes to smoothing short-term cash flow requirements in foreign currencies. Non-Deliverable Forward (NDF) A non-deliverable forward (NDF) contract is typically available in currencies that are restricted or controlled by their central governments, such as the Chinese yuan (CNY) or Indian rupee (INR). In these markets, the actual exchange of the local currency is restricted to local, resident banking institutions, while off-shore entities are typically prohibited from actually affecting local currency payments. In controlled economies such as China or India, they pay less tax when their customers outside of their borders pay them in USD or another hard currency. As such, many foreign customers unknowingly expose themselves to local currency risk even if they aren’t sending the local currency to their Chinese or Indian beneficiaries. A nearly constant rate of appreciation of the local currencies against the US dollar (especially the case with CNY) forces the local suppliers to increase prices for their exported products over time as the USD they receive is converted into gradually less INR or CNY. An NDF is a forward contract that provides a forward hedge but cannot be delivered upon. Instead, the contract is closed out or “fixed” at expiry, resulting in a marked- to-market gain or loss, which offsets the paper gain or loss that is achieved when the purchaser actually purchases the local currency from an onshore bank. Exotic currency forwards are relatively new products, available from select foreign exchange specialists, which combine the hedging characteristics of an NDF with the ability to deliver the local currency in restricted markets. Such contracts are not materially different from a standard major currency forward and provide corporate entities with both the means to hedge their currency risk and affect local currency payments to their suppliers. Page 7 of 10 l Foreign Exchange Risk Management http://payments.westernunion.com

Many companies are aware of hedging and employ hedging mechanisms. For the most part, evaluating and managing these risks is an ongoing and complicated task. As the foreign exchange market continues to evolve with economic changes, and as new products and services are offered daily, it is important that every company make risk management an ongoing and important task. What To Look For In A Currency Hedging Provider When looking for a provider to assist your company in minimizing currency risk there are many factors to consider, the first being which type of provider would best fit your needs: a bank, investment company or dedicated foreign exchange provider. Each type of provider has their own advantages and disadvantages. While your banking partner, financial institution or investment company may be able to execute a hedging position for you, they may not be the best option. These institutions are constrained by traditional banking hours, diverse operations and leveraged positions, meaning that they cannot dedicate their time solely to the intricacies of foreign exchange and hedging for risk management. In addition, they will rarely possess the ability to both execute a hedge and effect a local currency payment in many developing markets. Ensure that any provider in turn also deals with large commercial banks as opposed to brokers and investment banks. The leveraged positions and high risk investments held by many investment banks have been the cause of market turmoil as of late. Hedging your currency risk is very different for hedge funds that are highly leveraged with the goal of producing returns. These types of operations also expose your company to counterparty risk – the risk that companies or individuals will be unable to pay the contractual interest or principal on their obligations. Hedging against your currency risks protects your assets much like an insurance policy – it should not swap one form of risk for another. With this extremely complicated and time sensitive industry it is best to employ an expert that is knowledgeable and easily accessible when needed. Choose a provider that fits your needs who can provide specialized advice specific to the functions of your business as well as maintain a stable market position, staying away from any type of market speculation. Quick Checklist When Sourcing A Provider • Be sure to use a provider that offers a range of products – this doesn’t mean you need to find the FX provider that offers the most products - make sure it works for your needs and has the flexibility to change as the needs of your business change. • Ensure that the provider you choose employs experts in hedging – being aware Page 8 of 10 l Foreign Exchange Risk Management http://payments.westernunion.com

of hedging products and being able to book one is much different than knowing the intricacies of how, when and in what combination these products should be employed to achieve your company’s objectives. • Employ a provider that has exceptional customer service – after all, what good is a company if you aren’t able to call them up when you have a question and receive an informed answer? • As with any business, ensure that they are financially stable – make sure that the provider has sufficient size and stability to ensure that your company is well taken care of. • Ensure that they can help you when you need it – if you want to execute a transaction at 3am to take advantage of a key event or maintain international business hours, make sure that you can. • Online platforms are essential – make sure that the provider can provide you with an online account that is accessible at any time to execute a transaction as well as a system that can provide management reporting with respect to transaction status and can export information into your company’s financial software. • Security/compliance – Ensure that any provider you choose to work with meets and exceeds compliance and security regulations and is proactive to ensure the safety, accuracy and timeliness of all transactions. About the Author As Vice President of Foreign Exchange Trading at Custom House, Mark Frey is responsible for the company’s foreign exchange position, risk and cash management, as well as the implementation of Custom House’s corporate hedging policy and the management of inter-bank trading relationships. He is also responsible for relationship development with present and prospective clients, as well as their advisors. A graduate from the University of Calgary Economics Program, Mark is a candidate in both the Chartered Financial Analysts and Canadian Derivative Markets Specialists programs. Mark is a regular contributor for many leading financial newswires and publications, both online and off. He regularly authors the World Market Update newsletter writing on topics related to risk management, hedging and emerging market currency trading. Page 9 of 10 l Foreign Exchange Risk Management http://payments.westernunion.com

About Custom House, A Western Union Company Custom House, A Western Union Company, provides reliable, efficient international payment solutions for today’s business. We offer advanced, customized foreign exchange solutions, addressing the unique needs of small to mid-sized enterprises (SMEs) and global businesses that require support managing foreign exchange risk and international payments. Through our market-leading technology, strategic business relationships, and a worldwide network of trading offices we help our clients remain competitive when working in global markets. Western Union owns and operates Custom House along with its services under the Western Union name. Learn more about Custom House, A Western Union Company, visit http://payments.westernunion.com or www.customhouse.com Custom House, A Western Union Company Tel: 1.866.344.4583 Fax: 1.877.255.0669 http://payments.westernunion.com Regional Offices United States Canada Australia United Kingdom Custom House (USA) Ltd. Custom House ULC Custom House Currency Exchange Custom House Financial (UK) Tel. 1.866.344.4583 Global Head Office (Australia) Pty. Limited Limited Fax. 1.877.255.0669 517 Fort St. Level 6, 34 Hunter Street Company Number 04380026 http://payments.westernunion.com Victoria, BC V8W 1E7 Sydney, NSW 2000 Registered Office Address: Canada Telephone: 61.2.8001.2100 2nd Floor, 12 Appold Street Tel. 1.250.220.1015 Toll Free: 1.800.887.773 London, EC2A 2AW Fax. 1.250.412.0775 Fax: 61.2.8001.2122 Registered in England www.customhouse.ca www.customhouse.com.au Tel. 0845.882.4790 Australian Financial Services Fax. 0800.389.9432 Licence No: 238290 www.customhouseuk.co.uk ABN: 95 086 278 659 Custom House (USA) Ltd. is owned by the Canadian registered company Custom House ULC. Custom House Currency Exchange (Australia) Pty. Limited is owned by the Canadian registered company Custom House ULC. Custom House Financial (UK) Limited is owned by the Canadian registered company Custom House ULC. This report in whole or in part may not be duplicated, reproduced, stored in a retrieval system or retransmitted without prior written permission of Custom House ULC. Custom House has based the opinions expressed herein on information generally available to the public. Custom House makes no warranty concerning the accuracy of this information and specifically disclaims any liability whatsoever for any loss arising from trading decisions based on the opinions expressed and information contained herein. Such information and opinions are for general information only and are not intended to present advice with respect to matters reviewed and commented upon. This report is not directed to, or intended for distribution to or use by, any person or entity who is a citizen or resident of or located in any locality, state, country or other jurisdiction where such distribution, publication, availability or use would be contrary to law or regulation or which would subject Custom House ULC or its affiliates to any registration or licensing requirement within such jurisdiction. All material presented herein, unless specifically indicated otherwise, is under copyright to Custom House ULC. ©2009 Custom House ULC. All Rights Reserved.

Currency Hedging Strategies - Western Union GBP

by wugbp

Accessibility

Upload Details

Usage Rights

1 Embed 2

Statistics

Currency Hedging Strategies - Western Union GBP Document Transcript