THE plunge of the Australian dollar has once again highlighted a major recurring challenge faced by Australian exporters: How to translate a weaker Australian dollar into improved margins while maintaining international competitiveness.
The fact is that many exporters fail to reap the rewards inherently associated with favourable exchange rate movements.
There are several reasons for this. For instance, many manufacturers continue to base their hedging strategies on currency predictions that are inherently unreliable and misleading.
Also there is not sufficient appreciation of the fact that, unlike hedging tools, currency risk management strategies cannot be bought “off the rack”. And too many manufacturers obtain foreign currency risk management and hedging products from their bank without understanding how to use them effectively.
This article argues that for foreign currency risk management to be effective it must be treated as an integral component of any exporting enterprise. Handled in such a way, manufacturers are able to hedge their exchange rate risk while still being in a position to take advantage of favourable exchange rate movements.
Effectively this allows companies to compensate for hedging losses inevitably incurred in a sustained drop in the exchange rate. Known as Dynamic Hedging, this is a powerful approach to foreign currency risk management.
Step One is to accept that we cannot predict the exchange rate. Once that is the case, we can create a context, or structure, around which to construct foreign currency risk management strategies whose success is not contingent upon accurate predictions of the exchange rate. (A view on the exchange rate is important, but it should not be the sole or over-riding determinant.)
Step Two is to protect the firm from unfavourable exchange rate movements. This is relatively straightforward as many firms buy forward exchange contracts, a technology which has been around for along time and which also plays a role in Dynamic Hedging.
Step Three is to incorporate the best technologies and best practices available for the management of foreign currency risk. These technologies, mainly in the form of foreign currency options are aimed at taking advantage of favourable foreign currency exchange movements without adding to the risk.
THE TOOLS
The forward exchange contract is the most common hedging contract used, it is a binding contract entered into with a bank to buy, or sell, foreign currency at a future date, at a specified exchange rate. The exchange rate on the forward exchange contract is calculated using the spot rate and the interest rate differential between the contract currency pairs. For example, if the spot rate AUD/USD is 0.5400 today and the USDs will be received in 60 days we can buy a forward exchange contract to sell USDs for AUDs in 60 days at an exchange rate of 0.5410. The extra 10 points is a consequence of the different interest rates between the two countries.
Benefits of FECs are that the cash flows are known, the exchange rate is fixed, the transaction costs are low, and it is easy to implement.
Disadvantages associated with FECs are significant opportunity costs should the exchange rate move favourably during the contract period as the firm is obligated to deal at the contracted rate at maturity. This is a major disadvantage and does force companies to use currency predictions to achieve better hedging results, lack of flexibility, and cannot be used for uncertain cash flows.
A foreign currency option buyer has the right, but not the obligation to buy, or sell, a foreign currency at a specified exchange rate, at a future date. Plain or "vanilla" foreign currency options include an AUD Call option (the right to buy AUD) and an AUD Put option (the right to sell AUD). For hedging purposes an exporter will buy AUD Call options to hedge against an appreciation of the AUD. The specified exchange rate is known as the strike rate, and is chosen by the purchaser of the option.
Benefits of foreign currency options are that they provide protection against adverse exchange rate movements, allow the option holder to take advantage of favourable exchange rate movements, provide greater flexibility, and can be used to dynamically hedge the exchange rate.
Disadvantage is that the buyer must pay a premium upon entering into the contract.
Modern foreign currency risk management, such as Dynamic Hedging, combines the use of forward exchange contracts and foreign currency options within a strategic context.
The objectives of such hedging strategies are to establish a “worst case” rate, reduce the cost of the option premiums, and to take advantage of favourable exchange rate movements. Dynamic Hedging risk management strategies are tailored to the companies' specific needs and circumstances.