Foreign exchange (FX) volatility is one of the biggest risks faced by New Zealand businesses involved in cross-border trade.
Even in an average year the NZD moves as much as 15% up or down against the USD and in a volatile year it has been as much as 25%.Regardless of the nature of your exposure, FX risk can quickly wipe out your profit margins. So what can you do to protect your business against this volatility and smooth out the impact of unfavourable currency movements? While there are widely used products like FX forward contracts, effective foreign exchange risk management is more than just taking out forward cover.
1. Understand how material FX risk is to your business
Regardless of your exposure if you transact in a foreign currency you should understand the potential impact of currency volatility and plan for the impact during your budgeting process. The moment you realise you have an FX requirement you are exposed to currency risk which is why budgeting and accounting for FX risk is so important. The longer the timeframe between realising you have an exposure and the actual cash flow the bigger the risk. Foreign exchange specialists can help you understand the risk by considering recent volatility and modelling against your specific exposure as well as looking at the various options and costs of hedging.2. Have a plan
Even if your approach is to do nothing and simply use the spot rate on the day you should have a policy. Not all businesses need a detailed FX Policy but everyone should have a guideline. This can be as simple as a 1-2 page document which outlines a framework for managing your currency requirements. FX specialists will be able to help you with this and formulate an approach but you should include the following:- Who makes the FX hedging decisions
- How far forward to hedge
- If no hedging is permitted when is an invoice or receipt converted
- What hedging instruments to use- FX forwards, Vanilla Options, Structured Options etc
- How much to hedge at any given time
- Who to use- banks and /or FX specialists
3. Don’t rely on forecasts
A recent Reuters FX Poll from 40 economists had a range of 0.55-0.73 for the NZD/USD over the next 12 months. The bottom line is no one knows where the FX market will be in the future and if you did you wouldn’t be bothered importing or exporting when you could be making millions of dollars speculating in the FX market! Hedging foreign exchange risk isn’t about making a profit it’s about giving you more certainty and smoothing out the impact of unfavourable FX volatility.4. Only dealing with one provider
As businesses strive to grow and remain competitive managing all costs in your business is imperative but very few businesses receive competitive FX rates. While all FX rates are ultimately driven by the underlying wholesale market, the rates given to customers include spreads or margins of between 0.1- 5%. This means the cost to transfer money internationally on a $100k can vary by as $100- $5,000. Clearly you don’t want to be the business being charged 5%.While most people have a fair idea where the spot rate is on any given day (websites like XE.com publish the real-time wholesale mid rates), FX forward points are much harder to come by and can include huge spreads. If you have an active hedging program you should always have at least 2 providers to ensure you have sufficient liquidity to cover when required. Banks and FX specialists will have a set amount of credit appetite for any given customer which can restrict your ability to take out additional contracts.
5. We’ve always done it this way
Just because an approach to managing foreign exchange worked a few years ago doesn’t mean it’s relevant today. FX rates and the competitive environment are constantly changing. If you aren’t reviewing your policy on a regular basis you are at risk of using an outdated approach.