Simple Exchange Rate Risk Hedging for SMEs

As SMEs become increasingly active internationally, their currency exposures increase as well. At the same time, as we’ve seen in 2016, currency volatility is increasing due to rising uncertainty and turbulence in the global political and economic environment. Despite the fact that SMEs identify exchange rate risk as the most significant challenge they face when doing business internationally, the AFEX report found that only 13 percent actively hedge their currency exposures using currency risk management tools and 65 percent do not hedge their exposures at all.²

But exchange rate hedging need not be so difficult or complex that nearly two-thirds of SMEs end up avoiding it. Here is a brief explainer of some simple tools that SMEs can use to manage their exchange rate risk.

Managing Exchange Rate Risk With Forward Contracts

The heart of any exchange rate risk management strategy is likely to be the forward contract, which is a contract to buy or sell currencies at an agreed exchange rate on a particular date in the future. For example, if an SME in the U.K. has to pay a supplier in U.S. dollars on expiry of 90 days trade credit, a forward contract to buy U.S. dollars in 90 days will remove the risk that sterling will depreciate versus the dollar. That provides the SME with certainty regarding cash flow. Similarly, if our U.K. SME has given 90 days’ trade credit to a U.S. customer, a forward contract to sell dollars in 90 days will lock in the sterling value of the expected dollar payment. If there will be a series of payments over a defined period of time, a “window forward” can lock in the exchange rate for the entire series, removing exchange rate risk – i.e., the risk of adverse currency movements.

However, forward contracts don’t allow the business to profit from currency movements in its favour. For SMEs that prefer to retain the possibility of gaining from currency movements, there are several tools that can be used to limit the downside exchange rate risk without completely removing potential for upside benefits.

Using FX Orders To Limit Downside Exchange Rate Risk

Using an online platform that provides FX rate alerts and a range of simple FX trading strategies can enable an SME to manage its exchange rate risk exposure more proactively. Here are a couple of the tools that could be available:

• Limit orders are a form of forward contract in which the purchase or sale is made when a rising exchange rate reaches a pre-set limit.
• Stop loss orders are similar, but the purchase or sale is made when a falling exchange rate reaches a pre-set limit.

Here’s an example. The chief financial officer of an Australian SME wants to buy U.S. dollars for a supplier payment in 90 days. She suspects the AUD-USD exchange rate will move during that time, but she doesn’t want to lock in the exchange rate now using a forward contract because she doesn’t know in which direction it will move. Obviously, she will benefit if AUD rises versus the U.S. dollar and lose if it falls. So she issues a stop-loss order which will trigger a purchase when the AUD-USD exchange rate falls to US$0.74, for example, limiting her downside losses. If the exchange rate does not fall to the trigger level within the time frame specified for the stop-loss order, she will do a spot FX deal to buy U.S. dollars at the prevailing price.

Hedging Exchange Rate Risk With FX Derivatives

Many SMEs may find that forward contracts and FX orders are sufficient to manage their exchange rate risk. However, some might find that using simple derivative products enables them to manage their currency risk exposure better. The principal derivatives that SMEs might use are swaps and options.

In a forex swap, the parties involved agree to exchange equivalent amounts of two different currencies at an agreed rate, then exchange them back at the same rate on a specified later date. A forex swap is essentially a combination of a spot and a forward FX contract, or sometimes two forward FX contracts (this is known as a forward-forward swap).

Swaps can help companies avoid exchange rate risk on known future payments. For example, consider that our Australian SME has a large euro balance from sales in Europe, and it plans to pay its European suppliers in euros in a month’s time. In the meantime, it needs Australian dollars for day-to-day running costs. The CFO could sell euros for AUD now at the current spot price, and then in one month’s time buy euros for AUD at the spot price then prevailing. But this exposes the company to the risk of losses due to adverse currency exchange rate movements between the two spot transactions. So the CFO enters into an FX swap, simultaneously selling euros for AUD at the spot price and entering into a forward contract to buy AUD for euros at an agreed price in one month’s time.

Related to this is a currency swap, in which the SME swaps the interest and/or principal on a loan in one currency for the interest and/or principal on a loan in another. The interest rates can be either fixed or variable.

Currency swaps were traditionally used to avoid exchange controls, and in some developing countries they are still used for this purpose. Now, they are also widely used to finance projects where the expected returns will be in a different currency from the financing. For example, consider an SME setting up a production facility in Sweden to produce goods which will be sold mainly in the European Union. The SME must pay for the production facility in Swedish krona, but the revenue stream from the goods produced will be mostly in euros. So the SME borrows in krona to pay for the building of the new production facility, then swaps the loan into euros to eliminate exchange rate risk between its debt service obligations and its revenue stream.

Some corporations also use currency swaps to take advantage of cheaper funding costs in some currencies. For example, a U.S. corporation might issue euro-denominated bonds, known as “reverse Yankees”,³ and swap them for U.S. dollar bonds with a similar repayment profile, thus benefiting from lower eurozone interest rates.

Options confer the right, but not the obligation, to buy or sell a specified amount of currency at a given exchange rate, known as the “strike price”. Options that can only be exercised (i.e., the purchase or sale made) on the maturity date are known as “European” options; if an option can be exercised at any time up to its maturity date it is an “American” option. The purchaser of an option pays an amount known as a “premium” to the seller. Although options are financial derivatives, for SMEs they are best regarded as a form of insurance against exchange rate risk. They act much like limit and stop-loss orders, except that the buyer of the option is not obliged to make a purchase or sale when the strike price is reached.

The Takeaway:

SMEs can use a variety of hedging tools to manage exchange rate risk. For businesses that wish to eliminate all exchange rate risk, forward contracts can be sufficient. But for businesses that want the possibility of benefiting from positive exchange rate movements, FX orders and simple derivatives can help them form an effective exchange rate risk management strategy. However, not all products are suitable for all businesses, and cost can be an issue, especially for more complex structures. FX hedging does not have to be complex to be effective. A good rule for exchange rate risk management is: “keep it simple”.

Sources

1. AFEX Currency Risk Outlook 2015, Associated Foreign Exchange Holdings; https://www.afex.com/docs/AFEX_Currency_Risk_Outlook_2015.pdf
2. Ibid.
3. "Reverse Yankees dominate euro bond market", Financial Times; https://www.ft.com/content/e29ab99c-8ea7-11e5-a549-b89a1dfede9b