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Hedging is a common way for export companies to iron out any fluctuations in the foreign currencies they trade in.
Yoke Har Lee has more.
Exporters thinking about beating the foreign exchange market with their hedging stunts can forget about this risky pursuit. Small and medium-sized enterprises stand little chance of beating a market that is both complex and whimsical.
Even with the best minds in currency portfolio management, bigger companies often get stuck with foreign currency losses when they repatriate their earnings into New Zealand dollars.
The New Zealand market is filled with nightmarish stories of exporters seeing their profit margins turn into losses after accounting for fluctuations in the foreign currencies they have traded in, the major ones being the US dollar, Aussie dollar, Euro, Japanese yen, and increasingly, the Chinese renmenbi.
Companies that manage their hedging well are able to close out positions to profit from the currency gains. Fisher and Paykel Healthcare was able to report to shareholders the company’s currency hedging programme contributed $38 million to operating profit for its 2011 financial year.
In 1992 George Soros, the Hungarian-born hedge fund trader, sold US$10 billion worth of British pounds to make a lot of profit for his Quantum Fund, in a move that nearly crippled the Bank of England. Hedge funds exist for the purpose of making money by taking a position either against or for a particular investment tool, currencies included, for profits.
For exporters, these hedging success dreams are far from attainable. Cliff Brown, client advisor at Bancorp Treasury Services Ltd, says exporters’ focus should not be on making money off currency hedging but to keep a close watch on the health of their core business.
Not beating markets
Currency hedging is never about beating the market, Brown says. Hedging is all about deferring the impact of a currency’s fluctuation on the cost of running your business.
“This is one of the problems plaguing exporters – and the process is the same for everyone. The thing is not to start with hedging decisions but looking at your currency flows over the next six to 12 months and managing that against expectations for your cashflow.”
For most exporters in New Zealand, the most commonly used hedging tools against volatile foreign exchange markets is to enter into forward currency contracts or options contracts with a bank or financial institution trading currencies.
The forward contract allows the company to settle a currency at a specific point in time in the future, at a specific price. An options contract allows the company to either buy or sell a currency at a future time. The company pays a “premium” to take a position on these options contracts.
Brown says the usual downfall for exporters is that too many of them become too optimistic with their business performances. An exporter, he says, may provide full hedging for their expected receipts but often the business falls short of expectations.
“This leaves too much in the hedging with bad rates which are in turn costly to unwind.”
Best practice
A good approach to adopt is to begin with a projection of the busines’s likely performance. Have a clear handle on how to offset your busines’s incoming receipts against payments you have to make. If you have natural hedges, these relationships need to be clearly understood and built into the equation.
History has consistently proven that forecasts of currency movements can never be foolproof. What exporters should do instead is to work through how the movement in the currency would affect the cost of running the business.
“Go through the process, highlight the danger spots; that is, at which point does the trade cease to be profitable, or how will it affect the dynamics for the company? For example, should the dollar fall to 75 cents (per US dollar) or rise to 90 cents, ask yourself if the currency goes to a certain level, how much business will you still be doing at that level!” Brown says.
Whether you are trading $1 million or $50 million, the currency markets’ whimsical movement will still produce damaging impact if your business is no longer enjoying margins it used to enjoy because of the foreign exchange movements.
The plight of the SMEs
Marine system company Vesper Marine typifies what many small businesses in New Zealand go through. The company cannot ignore currency movements but cannot spend too much time worrying about hedging against its receipts as this could divert time and resources away from growing the business.
Founder Jeff Robins says the company tries to hedge when it makes sense by using advice given by financial institutions on the timing and movements of currencies. He admits, though, that he has no yardsticks to measure how effective that has been.
The fluctuations in the New Zealand dollar against major currencies also pose additional headaches for the company as it tries to set price points in various markets around the world.
“About 90 percent of our business is from exports. As we continue to grow, currency management is something we are going to have to focus on,” Robins says.
For airport system solutions company BCS, the key is trying to source local components as much as possible to build in natural hedges in the foreign markets it has projects in.
Patrick Teo, chief executive of BCS Group, says, “We do try to have a natural hedge by maximising local content as much as possible. We are quite lucky in that our business and operational model allows us to do this.
“Apart from a natural hedge, we have a company policy that aims to hedge approximately 60 percent of our foreign revenue,” he says, adding the company relies on external expert advice on hedging.
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Know your margins
Barry Squires, head of international business, New Zealand, at Westpac, agrees that exporters may not be equipped to manage currencies but what is within their capacity is to know how to make a margin for every sale they clinch in their business.
It makes sense, he says, to start by figuring out at what price points would a transaction no longer be making a profit for the company. A company with a large profit margin, he says, would most probably be able to tolerate a bigger percentage swing in a currency. The problem is most exporters do not have that kind of margin.
One hedging strategy used by some companies is to price their products only in New Zealand dollars. This means the companies have essentially transferred the risks of managing the currency to their buyers in foreign markets. The downside to this is the exporter would lose control over the product in those markets which in the longer term could present hidden risks to the company, Squires says.
A good strategy to adopt would be to understand how much risk your company can tolerate and take proportional hedges against the currency risks.
An exporter may, for instance, decide to take cover by getting a forward hedge contract for a maximum of 30 percent of his projected sales (based on historical sale patterns and projections) and over the next few months, add progressive cover for the rest of the projected sales, Squire advises.
“Depending on the cycle between the hedging and the cash conversion, an exporter might commit 100 percent of the order. What percentage they decide to cover depends on their view of the currency and the commodity being traded.
“One can over-hedge, especially in the volatile commodity markets. If you expect to sell at $3.50 per kg and the price falls to $2.50, you have more cover than you can use. You are going to introduce more risk than you need,” Squire says.
Tool to monitor hedges
Big companies have structured treasury departments monitoring currency movements and managing foreign exchange exposures. For those companies without this luxury, a new system being launched about half a year ago can give exporters an additional tool to help them build more complete profiles of their foreign currency and interest rate exposures.
Hedgebook is a web-based software programme. Exporters can use this tool to help them accurately provide transaction information which then helps them identify their exposures in a particular foreign currency.
Richard Eaddy, founder of Hedgebook says a company cannot hedge well without accurate financial information. The tool provides companies with “sensible parameters” on which to base their treasury management on.
He says the web-based system helps provide analysis of what has been covered and how much of a company’s foreign currency needs covering, with additional scenario-building tools for managing exposures.
Hedgebook is a joint venture between ETOS Limited, New Zealand’s leading provider of treasury outsourcing services, and Resolution Financial Software, a provider of derivative pricing advice in Australasia.
According to Squires from Westpac, not having a hedge could wipe out a small company. Experts recommend that small exporters use their banks’ knowledge to help them, while bigger companies should have a more structured treasury management policy.
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