Designing a currency hedging strategy requires some thought. The best outcomes result from a detailed process of analysis, testing, implementation, and ongoing modifications, but what if you just hedged 50% of your forecast?
It might sound like a quick and dirty approach to currency risk management – and it is – but, can a decent result be achieved with such a simple approach?
How it works
It's a very simple approach involving hedging half of your forecasted cash flows across a certain period of time. Here are the variables:
- Hedging period - how many weeks or months to hedge across
- Hedging interval - how often you will re-hedge (extend your coverage)
- Hedge ratio - the % of your forecast to hedge, in this case, it's 50%
Other than hedging a full financial year in one go (a 'static' hedge), the 'rolling' hedge is arguably best suited to this super-simple strategy.
To keep things simple, throughout this Blog, we'll use the following specs:
- $1 million payables per month
- Hedging across a 13-week period (three months)*
- Re-hedging monthly
- Hedging 50% of the forecast, so $0.5m per month
*We'll assume that three months is of significance for our fictional scenario - perhaps it relates to the average order length, or a pricing interval, or the inventory cycle.
Risk Reduction
The primary purpose of any currency hedging activity is the reduction of risk, that is lowering the impact of unfavourable exchange rate fluctuations if realised.
How much risk is our fictional company exposed to?
- Across a three-month period, a -5% movement would mean an increase of just over £120K at current market rates, whilst a -10% movement costs just over £256K
- The 1-month Value-at-Risk is £66K at a 95% confidence interval. This is, in simple terms, the maximum likely loss across 1 month in 95 out of 100 scenarios. The actual maximum loss (hidden in that missing 5%) could be far higher, of course.
These are big numbers, and probably well beyond the shareholders' risk tolerance!
The chart below shows the inherent risk (on the full exposure) and the residual risk (after the effects of a 50% hedge). As you can imagine, the risk is halved.
This is hopefully a lot more tolerable – if not, increase the hedging ratio until the numbers are small enough. Remember that this is about risk reduction, not elimination.
Pros:
- A simple approach
- Minimal hedge maintenance
- Effectively reduces currency risk
- Flexibility to cover a shortfall in payables vs forecast
- Allows participation in favourable spot movements
Cons:
- Hedge entry points (trade timing) may be unfavourable
- The level of downside protection may be insufficient
- Partial protection means losses may be significant
Workarounds:
- 'Participating Forward' options price worse than an equivalent Forward Contract but give 100% downside protection and 50% obligation - this is a potential solution if there is an asymmetry in the pain of downside risk vs the opportunity of upside gains
- Utilising Limit Orders at the point of trade execution/hedge entry may yield better outcomes by capturing intraday (or week) price fluctuations
- Increasing the hedging interval from once a month to fortnightly or weekly means there is less emphasis on the prevailing spot rate at that one moment in time, instead providing more of an average across the period.
What is a decent result?
This is a major issue – what are we trying to achieve and how do we know if the program is working?
- Tracking the ongoing exposure level is key - make sure this number is below a predetermined threshold (risk tolerance level) is the first step
- Comparing the average realised exchange rate versus the market is interesting but not as useful as comparing it to the company's budget rate - easy and impactful
- Calculating the volatility of realised exchange rates and comparing this to a predetermined threshold will give some steer on when to lift the hedging ratio to reduce the impact of rapidly moving rates
How would this have looked in 2024?
I simulated the full year of trading using our backtesting tool. Visually, you can see that the strategy missed out on some of the extreme peaks in the price, but it's clear that realised volatility was much lower. I added a $1.2500 budget rate - you can see how prices at the end of 2024 threatened this level, but the 13-week hedging strategy gave a buffer and bought the company time to make decisions. This is key. Time!
In terms of performance vs Spot, the strategy was down £11K on the year – that is just -0.12%, by the way. The average rate was $1.27634 vs average spot of $1.27791.
Summary
I always say that there is no copy-paste approach to currency hedging, but here we can see that a simple 50/50 approach could have several benefits. Each benefit, of course, has a potential downside, though. Any business decision-maker will need to carefully consider the risks as well as the benefits of any trading strategy. Speak to an experienced professional if you have any doubts.
This won't work for every business, but for those seeking a straightforward and simple solution, a rolling hedge across a time period that makes sense for them, and with a hedge ratio that sufficiently reduces risk on the one hand whilst not over-committing them on the other, is worth a serious look.
Take The Next Step...
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You can contact us for a review of your currency processes and for our guidance and suggestions at info@okumarkets.com or 0203 838 0250.
Thanks for reading 👋
