Drawbacks of common hedging methods

Forex risk management is a frustrating experience for most companies. A thousand things can go wrong at any time – the economy, the market, the forecasts, the regulations, the shipment and payment dates - and generally they do seem to go wrong all together, all the time, every time. If there is a profit, by chance or by design, it does not seem to last. Losses, when they inevitably come, tend to wipe out the profits of earlier years.

Little wonder that most companies tend to give up on forex risk management in disgust, saying, “Forex is not our business!”

We disagree. Forex is very much the business of every importer and exporter. And, tackled with a common sense business approach, it can even add to the bottomline instead of constantly subtracting from it. But, that is material for another article. In this article, we look at how companies generally deal with forex risk management, and the problems they face.

Method 1 – Do nothing

The commonest way to deal with forex risk is, of course, to wish it away, to do nothing. But sadly, as the School of Hard Knocks teaches all of us, avoiding a problem never works in the long run.

Method 2a – Hedge 100% on Day 1 with forwards

The second most common way to deal with the issue is to hedge away the forex risk completely, by closing the original exposure or position immediately, usually with a forward contract. This is a simplistic solution, commonly prescribed by textbooks that espouse the belief that “forex is not your business.” The implicit suggestion is that the company is incapable of managing forex risk.

The problem with this method is that although risk is undoubtedly eliminated, one ends up sacrificing all potential profit also. Another problem is that this method is easy to adopt for the exporter who earns the forward premium, but is difficult to justify for the importer who has to pay forward premium.

Method 2b – Selective hedging with Forwards

A variation of the total hedge method is to hedge selectively, based on currency forecasts. The problem with this method is that one doesn’t know whether a forecast is going to be right or wrong. Success cannot be anticipated, leave alone guaranteed. In case, the forecast is prepared by the company itself, there is an additional risk of the forecast turning out to be biased. For instance, there’s a danger that an importer will be biased towards a weaker dollar while an exporter would say that the dollar is going to rise. Thus, it helps to take forecasts from an external, professional forecaster, whose work is considered reliable.

Method 3 – Hedge 100% on Day 1 with Options

The third, much less common way to hedge is to use Options as the exclusive hedging tool, rather than the forward contract. The benefit is that Options allow the company to partake of potential profit if the market moves in its favour, while eliminating the risk of an unfavourable move. It is the best of both worlds. Sadly, options can be costly and are justifiable only in trending markets. Further, most companies, especially exporters (who are used to receiving forward premium) do not have a hedging cost budget. This prevents them from paying the option premium.

Is there a way out?

Alright, we’ve pointed out the flaws in the common risk management methods. Does this mean there’s no hope for beleaguered company managements? Does it mean there is no merit in what companies are currently doing?

No, things are not hopeless and there is, undoubtedly, an element of wisdom in each of the methods we have examined. For instance, while it is true that forex risk management is indeed your business, it is equally true that forex trading is not your business.

Further, we would definitely suggest using good forecasts as an essential tool in risk management. We also believe that hedging is a must and that both Forwards and Options should be used for hedging.

Forex risk management is still evolving and wise elements of common hedging strategies can be combined to create an effective and profitable forex hedging methodology. It can be done. We have done it. You can also.

(The author is Chief Currency Strategist at a kshitij.com. The views are personal.

He can be reached at >vikram@kshitij.com )

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