04 Dec, 2017 (Updated 12 Dec, 2017)
It’s a well-known fact that significant exchange rate fluctuations can have a major impact on exporters and importers.
Hedging currencies and interest rates is one way of protecting yourself against major changes in the markets. It can also simplify the process of preparing a budget and making predictions.
“When you draw up a budget for your business, it allows scope for a number of assumptions concerning volumes, production and demand,” explains Ilkka Kesti, FX Risk Adviser at Nordea Markets. “Then on top of that there’s the uncertainty surrounding currency and interest rate risks.
Companies set their budget rates for currencies and interest rates in lots of different ways
“Companies set their budget rates for currencies and interest rates in lots of different ways,” he says. “Since the budget should be closely linked to the underlying business, it can be sensible to base budget rates on the same exchange rates that are used when pricing the company’s products. Otherwise prevailing exchange rates can also be an appropriate starting point.
“Some companies are more forward-looking in their budgeting and choose exchange rates and interest rates based on forecasts,” Kesti explains. “Forecasting financial markets is not easy, however, even in the short term, and currency forecasts presented by banks, for example, cannot be regarded as a guarantee of what the future trend will be. It can therefore be good to take account of normal market movements. A company that has already hedged some of its currency and interest rate exposure is often advised to use the hedged rates when budgeting. On the other hand, it is rarely a good idea to use budget rates that deviate significantly from current levels or the hedged rates. If you pay too much regard to risks when budgeting, it can undermine the budget’s purpose as a benchmark and control function for the business.”
Important to be aware of the company’s sensitivity
Viktoria Olesen, Interest Rate Risk Analyst at Risk Advisory, Nordea Markets, says risk management can involve drawing parallels with your own financial situation and loans. “The more you focus on it, the more aware you become,” she says. “It’s largely about being aware of your currency flows and interest rate positions. How sensitive is the company? What happens if the interest rate rises by one percentage point? What happens if the dollar strengthens by 10 percent? Such analyses and risk assessments provide a solid basis for managing risk.
“And,” she adds, “they reveal how much companies can vary in terms of their risk appetite. But it’s essentially about creating a situation that you feel happy with as a company – a situation that allows you the freedom to focus on your business and not worry about exchange rate and interest rate fluctuations.”
One way of reducing risk is to hedge interest expenses and currency flows. The company enters into an agreement with the bank in which it locks in its interest rate or currency flow. This can be done by fixing the rate at a particular level or by buying currency forward contracts.
Many companies have no hedging strategy
Although there is greater awareness now of the effect of currency movements, many companies still lack an explicit currency strategy. One reason may be that it was less common 20 or 30 years ago for companies to operate directly on an international market. Digitalisation has changed all that.
“These days, many companies are global right from the start,” Kesti says. “For example, it could be an online store with a global reach from the first day of trading.”
Unexpected events on global market can hit hard
“Currency fluctuations can have major consequences for companies that aren’t prepared,” Kesti says. “At the end of 2014, for example, the dollar strengthened against the Swedish krona by more than 30 percent in a short space of time, and clearly if a company imports products priced in dollars, that causes a huge difference that can require adjustments to the business model or pricing.”
Currency hedging can also be a way of buying time when unexpected events occur, such as Brexit or the collapse of Lehman Brothers. If a company has hedged its flows, it gains a degree of certainty, and results remain stable in an uncertain world. You buy time to allow for adjustments to the new situation.
Three steps for managing risk
The first step is to analyse the company’s exposures – then you can assess how sensitive the company is to these risks. You analyse your currency streams and calculate how much revenue the company would lose in the event that the dollar or euro suddenly plummeted in value. Or, if they strengthen, how would that impact the company’s costs and profit?
The same exercise can be carried out in relation to interest expenses. What impact would a higher interest rate have on earnings?
The analysis provides a clear basis for decisions, which you can use to devise a management strategy for your currency and interest rate risks. For example, you can hedge some of your currency exposure or spread loans across fixed-term periods of varying lengths. The risk level that a company chooses should be linked to the business and factors in which the company has expertise and can assess rather than to trends on the world’s currency and interest rate markets. It also allows entrepreneurs scope to focus on their business and means they don’t have to worry about market changes.
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