Business mentor: Hedging for dollar swings

Q. My small business has done a small amount of exporting but we would like to get more active with it. With the New Zealand dollar being so high at the moment, is there anything I can do to protect myself from earning less money?

A. Westpac's senior currency strategist Johnathan Bayley replies:

Yes, the New Zealand dollar is high in the context of the exchange rate cycle, and this is making life difficult for our exporters.

The good news is that there are ways of reducing the impact on your earnings.

In considering this issue there are two important things to remember. The first is that exchange rates move in cycles and it is essential to consider the impact the currency will have on your business throughout the cycle. The second is that irrespective of your view (or that of the experts) on exchange rate direction, the risk must still be managed.

Before looking at the options available to manage risk, exporters must take into account the cyclical nature of the exchange rate and make the assumption that the currency will continue to fluctuate over the long term.

The New Zealand dollar recently traded as high as 71USc, yet its appreciation is not unusual by historical standards - the exchange rate moved above 70USc in both 1988 and 2000.

As in previous cycles, we can expect the currency to return to more moderate levels over time and already there are signs that the currency is near a peak.

Although the likelihood that the exchange rate will lower this year may be reassuring, there is still a need for exporters to obtain protection against unexpected currency strength, given the inherent uncertainty.

There are two main options available to protect you from exchange rate risk: forward exchange contracts, and options-based cover.

Many businesses hedge their foreign currency payments and receivables using Forward Exchange Contracts (FECs). A FEC is where a commitment to deliver a certain amount of foreign exchange some time in the future is made to the bank at an exchange rate that is agreed today. These do provide certainty regarding the rate at which you will sell your foreign currency and if used consistently over the cycle will smooth the impact of exchange rate volatility on earnings. The risk is that an exporter may miss the benefits of currency depreciation.

Exporters and importers are now using foreign currency options (and option-based solutions) as an alternative, and to an increasing extent. As with an FEC, a currency option will provide an exporter with a worst-case rate and thus protection from currency appreciation. Unlike an FEC, it will also offer the exporter the chance to obtain a lower exchange rate should the currency weaken.

Simple currency options can be purchased for a premium (in a similar way to ordinary insurance). As in the case of general insurance, the exchange rate option (insurance) premium should be compared against the value of the asset that is being protected. Just as no one is disappointed to find that their car has not been stolen despite having bought insurance, no one should feel disappointed if the currency did not appreciate to a point where they needed to exercise their option.

Overall, by using a currency option, you can remove exchange rate uncertainty from your business. The option holder gets both flexibility and surety in otherwise unpredictable foreign exchange markets. Currency options are not just for large corporates - an increasing number of small importers and exporters use them and cover can be obtained for an amount as small as $50,000.

For further information call Westpac's foreign exchange team on 0800 659-307.

Westpac Institutional Bank

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Answers are courtesy of Spring - A State of Mind for Business.