Navigating foreign currency hedging risk

As more U.S. companies engage in business globally, they need to evaluate the potential advantages of collecting and paying in the local currencies of their foreign customers and suppliers. By assuming the foreign exchange (FX) risk associated with such transactions, a company can often improve its bottom line and tamp down earnings volatility, among other benefits.

Because the FX market can be volatile, if you do decide to conduct transactions in foreign currency, it’s important to manage the related risk. But does your organization’s treasury department have the knowledge and resources to implement and execute currency hedging? Many companies see that as a challenge.

Fortunately, the solution can be as easy as partnering with your bank’s foreign exchange professionals and implementing a currency exchange risk management program that you can “set and forget,” says Paula Comings, head of FX Sales at U.S. Bank.

Why transact in foreign currency?

Transacting exclusively in U.S. dollars (USD) with customers and vendors in non-USD geographies can have negative financial consequences.

If you are an exporter, collecting in USD shifts the currency risk management responsibilities to your overseas customer. Due to this added burden, your product may end up being more expensive and less competitive from the customer’s perspective.

If you are sourcing your goods or materials from overseas, and your foreign vendors are invoicing you in USD — and managing the related currency exchange risk — you surrender transparency and reduce your ability to negotiate pricing.

Transacting in your overseas trading partners’ local currency is a bit more complicated but can be financially savvy. In many cases, the ability to control the exchange rate can provide a competitive advantage, enhance liquidity and improve cash forecasting.

Employing risk management tools

If you go this route, you will need to manage the currency exchange risk. This can involve a range of strategies, from opening a foreign currency account for netting payables and receivables, to the hedging of foreign exchange where it makes sense.

Hedging can mitigate the risks created by FX market volatility, including reducing earnings volatility and protecting future cash flows or asset values. The use of fundamental hedging instruments such as forward contracts and options might seem intimidating at first, but with the help of a knowledgeable FX professional, they’re not difficult to execute.

Resource considerations

Organizations often allow the complexities of currency hedging to dissuade them from assuming and managing FX risk. Comings cites the example of a U.S. seafood processor that sources its fish from countries around the world. She recently spoke to one of its treasury managers about currency hedging.

“He said: ‘We have a three-person treasury team. We do not have time to think about foreign exchange risk. We pay dollars to our suppliers because we don’t want to think about it.’”

The treasury manager admitted he believed the company could improve its profit margins by 2% to 5% by developing and executing a currency exchange risk management strategy, but resource considerations had prevented the business from trying.

Comings’ response? If you lean on your bank, you can do it.

Set and forget: a programmatic approach

To address resource constraints, and promote consistency and efficiency, Comings suggests that companies consider establishing an FX hedging program where comprehensive parameters are established up front, and the program runs on its own without treasury managers having to make daily decisions.

This type of program defines all facets of the hedges to be placed, including:

• Hedge ratio: the size of the hedge vs. the underlying exposure
• Cadence: monthly or quarterly hedging
• Tenor: how far forward the hedges extend
• Product selection: forwards, collars, purchased options
• Currency: Which currencies does the program target?

A policy-driven, systematic program could, for instance, require a company to hedge 25% of 3-month, 6-month, 9-month and 1-year exposures in the euro, Canadian dollar and Japanese yen on the last business day of the month. The strategy removes risk manager discretion that could lead to mistiming markets, offering some of the same benefits as dollar-cost averaging in investing.

“The simplicity of setting up a program like this makes it a useful place for treasury professionals to begin their hedging journey,” says Charles Val, managing director of FX Sales at U.S. Bank.

A difference maker

Utilizing a systematic and programmatic approach to currency exchange risk management can make the difference between winning or losing financial results.

“Many companies that employ this disciplined approach are able to increase the certainty and reduce the volatility of their returns and earnings from period to period,” Comings says. “It’s the ones that aren’t as disciplined that you see in the headlines because of their earnings misses and restatements — a result of their trying to be too opportunistic and failing to sufficiently hedge their foreign transactions.”

Partnering with U.S. Bank allows you to access advisors with decades of experience to navigate the challenges and nuances of the FX market. Connect with an expert to help your business with global cash flow, foreign exchange and international financing challenges.

Note that the foregoing is not applicable to consumers, nor is foreign exchange hedging appropriate for all businesses. These transactions are subject to regulatory qualifications; U.S. Bank cannot enter into hedging transactions with you unless all regulatory requirements are satisfied. The information contained herein does not constitute an offer, a commitment, or solicitation to engage in any products or transactions and is not intended as financial, legal, tax, or accounting advice. All hedging transactions are arm's length transactions, entered into on a principal basis, to be negotiated by each party acting in its own best interests. Before entering into any transaction, you, along with your own financial, legal, tax, accounting and other professionals, should conduct a thorough evaluation of any proposed transaction and determine whether or not this transaction is right for you. Note that hedging transactions are subject to market conditions at the time of trading, final credit approval and agreement upon all terms. The content of the foregoing article is provided for your informational purposes only and is not derived from research conducted by U.S. Bank or any of its affiliates. The information is derived from internal and external sources that we believe are reliable, but we do not warrant their completeness or accuracy, it is subject to change without notice and we are not responsible for its use or to keep the information updated. Foreign-denominated funds are subject to foreign currency exchange risk. Customers are not protected against foreign currency exchange rate fluctuations by FDIC insurance, or any other insurance or guaranty program. The products and services described herein are available through U.S. Bank National Association and are not bank deposits, are not insured by the FDIC or any federal government agency, nor are they guaranteed by U.S. Bank National Association. Neither we nor any of our affiliates are acting as your agent, broker, advisor or fiduciary in connection with any such transaction, and if we (or any of our affiliates) are otherwise engaged to act in such capacity in connection with other products and services, the engagement will be deemed to exclude any hedging transaction unless we otherwise agree in writing. This disclosure does not outline all risks related to the transactions. Prior to engaging in hedging transactions, please see the ISDA General Disclosure Statement for Transactions, including the Disclosure Statement for Foreign Exchange Transactions, and additional product disclosures provided to you by U.S. Bank National Association prior to the execution of any forward, non-deliverable forward or foreign exchange options.