In March, we introduced the FX Hedging Cycle – a five-step approach to managing foreign exchange risk – to share the concepts of identifying exposure to FX risk, setting objectives, and creating a plan to manage your risk. A crucial component which underpins each of these steps is understanding which exchange rate level you are trying to manage risk for. This level is known as a budgeted rate.
This month, we’ll take a closer look at the importance of budgeted rates and the concept of setting hedge ratios.
Budgeted rates tie in directly with a key element of almost all foreign exchange hedging programs: protecting your profit margins. A budgeted rate represents the exchange rate at which you can profitably operate at your desired margins.
Once your budgeted rates are established, you can secure those rates with hedging contracts to ensure your profitability is protected. Understanding your budgeted rate is therefore crucial to achieving the goal of protecting your profit margins.
An ideal time to consider your budgeted rate is when you identify and categorise your exposures. Not all budgeted rates are created equally. How these are established will differ significantly from business to business and exposure to exposure. The timeframe for which a budgeted rate is set will also vary greatly.
Ultimately, you need to calculate what the exchange rate needs to be for you to be profitable on that exposure. The key input in establishing your budgeted rate is your gross margin. This might be done on an annualised, seasonal, or even product by product basis. Your budgeted rate will typically tie in with the category of exposure you are managing.
Simply put, securing budgeted rates through hedging allows you to forget about potential foreign exchange rate movements and get on with what you do best. Or, as some put it, it helps you sleep at night.
Your budgeted rate will likely depend on more than just your desired margin. Budgeted rates can be impacted by your customer’s expectations around pricing, the spot rate on the day, your own budgeting processes, the timeframe for an exposure, or the level of risk your business is willing to take.
Achieving (or beating) a budgeted rate is a bit like being the unsung hero of your organisation. You have ensured the profitability of your operations despite wildly volatile exchange rates. There is usually little praise for achieving a budgeted rate, however, there are often plenty of issues if budgeted rates are not achieved.
By failing to achieve budgeted rates, you may be putting at risk your organisation’s profitability or financial position. Not only would you find the board of directors and shareholders are unhappy, but many downstream stakeholders might also be affected. Customers might have to suffer price increases. Employees variable remuneration might be impacted due to lower profitability. Other company initiatives might be cut as cashflow tightens. These are just some of the reasons why understanding the budgeted rate your business is working towards is so important.
Of course, there is always potential to outperform budgeted rates and secure FX gains. Secured FX gains increase the profitability of your business over budget. FX gains can help fund overperformance and enable your business to invest in other areas. FX losses, on the other hand, feed straight into the bottom line.
A good FX hedging strategy will allow for moderate FX gains to be accumulated over the financial year, providing a buffer for other shocks, and ensuring profitability for your main line of business.
When considering your budgeted rate, it may also be worth considering variations of such a rate. These might include:
An Australian furniture importer is gearing up for the summer season. They are looking at buying USD 12 million of furniture at a budgeted rate of 0.7200, and budget that sales will reach AUD 18.75 million. Their goal is for double-digit gross margins at 11%, with a stretch goal of 15% based on strategic hedging. Here are how the numbers look:
The key is, of course, that the budgeted rate of 0.7200 (or better) is secured through hedging contracts.
This month we will also look at Hedge Ratios: the value of foreign exchange contracts that are in place versus your identified exposure. They are typically expressed as a percentage. For example, a business with foreign exchange hedging contracts in place of USD 10 million dollars, with an identified exposure of USD 12 million dollars, represents a hedge ratio of 83.3%.
In our February article, ‘Why Hedge?’, we identified four common approaches to hedging. Choosing your approach will help you determine your hedge ratio.
There are risks and rewards at play when setting hedge ratios. The overarching objective is usually to protect profit margins, which makes the minimum hedge ratio very important.
Gross margin often has a deciding impact on your hedge ratios, either when setting your desired hedge ratios at the outset or when operating within a pre-defined range.
Unfortunately, in business, not all exposures are created equal and sometimes you may be hedging against a forecast exposure with a lower degree of certainty. In this case, it is typical to either: a) apply the hedge ratio to the most conservative forecast, b) utilise a lower hedge ratio or c) utilise more sophisticated foreign exchange hedging products that are tailored to your specific requirements.
Establishing budget rates and then securing FX contracts against these is an effective way of ensuring profitability for your business. If it is time for your FX program to be reviewed, please do contact us today for a free initial consultation.
I’ll end with a quote from the most powerful man in the world – the Chair of the US Federal Reserve:
“Alignment of business strategy and risk appetite should minimize the firm’s exposure to large and unexpected losses. In addition, the firm’s risk management capabilities need to commensurate with the risks it expects to take.” – Jerome Powell, Chair of the US Federal Reserve
If your risk management capabilities would benefit from a team that is focused on developing and implementing the best plan for you – contact us today.
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