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3 Misconceptions About Currency Hedging

For businesses that handle operations in more than a single, domestic currency, unpredictable exchange rates pose a real threat to. READ MORE

For businesses that handle operations in more than a single, domestic currency, unpredictable exchange rates pose a real threat to their profitability, resources, and time.


Large corporations (with a dedicated, in-house treasury department) have used currency hedging to protect from losses for decades. This service is now readily available to smaller corporations too, without the need for them to hire, manage, and fund an in-house treasury desk. But even so, many business owners avoid currency hedging like the plague. Why is that?


Let’s look at some of these popular (yet unreliable) assumptions.


Currency hedging is speculative and risky.


#1: Currency hedging is speculative and risky.


Public perspective of hedge funds must be the reason for this misplaced assumption. In actual fact, currency hedging and hedge funds have less in common than you’d think.


Unlike hedge funds, which essentially use loans to make bets on what might happen in markets (speculative, risky), currency hedging is part of a strategy, based on known variables and a defined goal, to protect a business from foreign exchange (FX) losses. Hedge funds are designed to take on market risk, whereas currency hedging minimizes risk from exchange rate volatility.


The objective of currency hedging is not to maximize profits through currency speculation but rather to minimize the risk that your company is exposed to. A currency strategy can involve making an informed decision to do nothing. It can also consist of partial or full protection, which offer the ability to benefit from positive market changes while protecting from negative ones. A hedging strategy is essentially an insurance policy against the adverse effects of currency fluctuations and economic conditions that are out of your control. In the same way you would insure your business from fire or theft, hedging insures your company’s currency assets from unforeseen changes in the global foreign exchange market.


Currency hedging ensures that the success of your business is determined by its operations and not unpredictable economic factors and volatile currency rates. It acts as a stabilizing mechanism which allows a company to project future cash flows – the valuation and reporting requirement for most businesses – with better certainty. Currency hedging involves proactively taking measures to offset uncertainty in international markets, exchange rates, or a respective country’s economic strength.


Why should I bother?
Exchange rates will eventually even out.

#2: Why should I bother? Exchange rates will eventually even out.


What goes up, must come down – right? Some people believe that, over the long term, gains and losses associated with exchange rates will average out and there is no need to protect against foreign currency fluctuations. But what would be considered long term?


As the saying goes, markets can remain irrational longer than you can remain solvent. Betting on long-term trends or a return to historical averages can become very damaging when markets shift dramatically over the short term, as they have in recent months.


Prepared decision-makers will often lean towards implementing hedges for large, non-recurring business expenses or projects with specific currency exposures. If the net cost or benefit of such a project is at risk if a currency devaluation occurs, putting a currency hedge in place is definitely practical.


However, even smaller or recurring business expenses should be hedged if they are core to the operations and financial performance of a firm, especially if profit margins are slim and easily affected by a devaluation in the currency.

If the viability of your entire business is put at risk should currency markets move unfavourably, the implementation of a currency hedge should be a no-brainer.


You are not exposed to exchange rate risk if you conduct your business solely in US dollars

#3: You are not exposed to exchange rate risk if you conduct your business solely in US dollars.

Here lies a very basic example of what some refer to as a “natural hedge”. However, for businesses that are dealing internationally, this is not typically effective for removing foreign exchange risk.

Currency risk affects companies that operate in multiple countries, companies that invest in operations abroad, and companies that import or export their goods to other countries directly or indirectly through their suppliers. Some businesses believe that, if they hold a US bank account and restrict themselves and their business partners to only sending or receiving currency in US dollars, they will be unaffected by currency market movements. However, this simply places the responsibility on another business or person to handle the exchange of USD to their working currency.

In addition, your business will still require domestic currency for things like overhead costs and payroll. It’s rare for balances to even out across your bank accounts, and exchange from USD to your home currency should be expected and planned for.

Even if you believe that you are not directly exposed to currencies outside of your domestic currency, the chances are likely that you are. Companies that don’t directly deal in foreign currency may be inadvertently impacted via suppliers if they deal in any foreign markets. For example, when a liquor distributor purchases imported products from European wine regions, they would be exposed to economic conditions in Europe even if they’re paying for a “domestic” order in USD or in their home currency. This is because, at some point in the supply chain, there would have been a transaction in euros or another European currency and the currency risk (typically in the form of a buffer – an increase in price to protect from exchange rate fluctuations) would be passed along. As such, when US dollars (or domestic currencies) are used to import goods, their purchasing power is continually diminished along the supply chain.

While business owners may choose to operate from a US bank account for their international dealings for simplicity, they’re missing out several competitive advantages because they’re essentially giving away control. This could amount to increases in costs (translating to decreased margins or less competitive pricing), missed opportunities to arbitrage (buy low and sell high), and lack of clarity overall when it comes to their business’s profit margins and profitability.

Nowadays, it’s both easy and inexpensive to partner with an FX risk manager, no matter the size of business. By controlling for known variables and planning for uncertainties in the market, smart business owners effectively use currency hedging to protect and benefit their business, rather than falling prey to these common misconceptions.

We are offering open, no strings consulting to businesses facing FX uncertainty during the COVID-19 pandemic.