3-minute read
Hedging business currency exposure doesn't need to be a long, complex process. Ultimately, it comes down to: how much, how far, and how often.
Many businesses fall into one of two camps. They either do nothing and hope for the best, or they panic-trade the moment the news looks grim or "good". Neither is a strategy. A real strategy involves answering two fundamental questions: How much? and How far? ... How often, we'll come to later.
The Three Pillars of Your Decision
Before you even look at a live rate, you need to look at your own books. We break this down into three pillars: Visibility, Certainty, and Sensitivity.
1. Visibility: What do you actually know?
Visibility is about the size and timing of your known exposures. Do you have a signed contract for a €500,000 shipment arriving in six months? That’s high visibility. Do you think you’ll probably sell about $1m worth of widgets in the US next year based on a "gut feeling" from the sales director? That’s lower visibility.
The clearer your view of the future, the further out you can afford to look. If your visibility is murky, you’re better off staying closer to the present.
2. Certainty: How reliable is your forecast?
This is where people often trip up. Forecasts are not facts; they are educated guesses. If your business has a 95% historical accuracy on its three-month forecasts, you can hedge a higher percentage of that amount. If your sales are seasonal or volatile, hedging 100% of a "maybe" is just gambling in a different way or direction.
3. Sensitivity: How much pain can you take?
This is chiefly about your profit margin, but also your pricing and re-pricing strategy. If you’re operating on a razor-thin 3% margin, a 5% move in the exchange rate more than hurts. If you have a 40% margin, you have more buffer to absorb market swings. The more sensitive your bottom line is to rate changes, the more aggressive your hedging should be. Likewise, if you are unable to easily re-price in response to changes in the FX rate, you may want to hedge to a higher percentage.
Choosing Your Programme: Static, Rolling, or Layered?
Once you know what you’re dealing with, you need a framework to execute. In the FX world, we usually talk about three main types of hedging programmes.
The Static Programme (Set and Forget)
Typically, a business will set its budget rate at the start of the financial year and hedge up to 100% of its expected requirements for the next 12 months using forward contracts or options.
- The Pro: You know exactly what your costs are. Complete budget certainty.
- The Con: It’s incredibly rigid. If the market moves 10% in your favour, you’re stuck with the old rate while your competitors might be enjoying cheaper imports. It can also produce an annual cliff-edge in achieved rates if the market moves signficantly from oner period to another.
The Rolling Programme (Constant Maintenance)
A rolling programme involves maintaining a constant hedge ratio over a set period. For example, you might decide to always be 50% hedged for the next 6 months. Every month, as the oldest hedge matures, you put on a new one at the end of the queue.
- The Pro: It smooths out volatility. You’re never fully exposed, or fully locked in.
- The Con: It requires more active management and regular trading.
The Layered Programme (The Smoothing King)
This is our preferred approach for most SMEs. You use a tapered profile where you hedge a higher percentage of near-term dates and a lower percentage of dates further out. For example:
- Months 1-3: 75% hedged
- Months 4-6: 50% hedged
- Months 7-9: 25% hedged
As time moves forward, you "layer" in more protection. This provides the best of both worlds: protection against immediate shocks and flexibility to capture better rates in the future, as well as allowing for medium-term cash flow forecast changes.
Over-hedging vs. Under-hedging
Balance is key because the extremes are dangerous.
Under-hedging: The "Hope" Strategy
Under-hedging is leaving too much to chance. If you only hedge 10% of your needs and the market turns against you, your margins erode instantly. You’re essentially at the mercy of the market. It’s a stressful way to run a business.
Over-hedging: The Hidden Risk
Over-hedging happens when you hedge more than you actually end up needing (perhaps because a project was cancelled or due to a "leveraged" option trade).
If you've booked a forward contract for $1m but only need $800k, you still have to settle that extra $200k, or sell it back to the market at the prevailing rate. If the market has moved against you, you’ll be buying that currency at a loss for no reason. Plus, there’s the risk of margin calls: where the bank/broker asks for more cash if the market value of your contracts drops significantly.
Why 100% isn't always the goal: Forecasts change – hedging 100% of a forecast is effectively making a bet that your forecast is 100% perfect. The goal isn't 100% risk reduction; it is achieving a reduction in risk to tolerable levels without adding further risk (margin calls, over-hedging etc.).
What’s Your Risk Tolerance?
Your "How Much and How Far" depends heavily on your business's unique sales, stock, and pricing characteristics, as well as its financial health. There’s no shame in being conservative, just as there’s no inherent glory in being moderate.
The Conservative Approach
- Priority: Stability and peace of mind.
- Strategy: High hedge ratios (70-90%), using long-term forwards to lock in rates.
- Best for: Low-margin businesses or those with very fixed pricing models.
The Moderate Approach
- Priority: Balancing protection with opportunity.
- Strategy: A mix of spot trades and forwards in a layered or rolling programme.
- Best for: Businesses with higher margins or those who have (or need) the flexibility to adjust their own pricing if the currency moves.
Practical Steps to Get Started
If you’re feeling a bit overwhelmed, don’t worry. You don’t need to build a complex algorithmic model by Monday morning. Start with these simple steps:
- Audit your data: Get a clear picture of your cash flows for the next 12 months. Separate the "definite" from the "maybe."
- Define your "Pain Threshold": At what exchange rate does your profit disappear? That’s your "Floor." Your strategy should ensure you never hit it. You can find more on this in our currency risk guide.
- Start small: You don't have to hedge everything at once. Start by covering 25% of your certain exposures and see how it feels.
- Review regularly: An FX strategy isn't a "set and forget" document. Review it at least once a quarter to make sure it still aligns with your business goals.
Ask Oku Markets for Help
Finding the right balance in your FX strategy isn't about predicting the future. It’s about managing the uncertainty of the future. Whether you need a simple fixed forward to cover a single invoice or a sophisticated layered programme for global operations, the goal is the same: protecting your hard-earned margins so you can focus on growing your business.
Don't let the "How Much and How Far" keep you up at night. Understand your pillars, pick a programme that fits your flow, and keep a healthy respect for the risks of over-committing.
We help SMEs design practical, no-nonsense hedging strategies that actually make sense for their business. No jargon, no over-engineering: just sensible risk management.
Get in touch at info@okumarkets.com or 0203 838 0250 for a straight-talking review of your currency risks. We can design your FX strategy for you!
Thanks for reading 👋
