Not even 'experts' can foretell future currency market moves, writes Earl White of Bancorp Treasury Services.
Currency hedging is something all small businesses with international aspirations should think about. It's important to look at currency risk as part of the business's bigger financial picture.
As a small business, 90 per cent of whose customers are overseas (Australia, North America, the UK), should we have a formal
currency hedging policy?
It is vital for any business - particularly those with a significant offshore customer base - to have control over income levels and to actively manage currency risk. Small businesses are often more exposed to financial distress in this situation than larger organisations which may have natural hedges through diverse markets and products.
Developing a currency hedging policy is the first step to managing this risk. It need not be complicated and may simply state how currency risk is to be managed, noting whether everything is to be covered at all times or specifying instances where no cover is to be taken. The key is to demonstrate that the issues have been thought about, potential bad outcomes quantified and steps put in place to manage or mitigate these outcomes.
Having a regularly reviewed policy ensures risks are thought about on an ongoing basis. This will provide the business with a much higher degree of control, enabling it to mitigate the impact of large (ongoing) currency moves that could materially impact on the operation's ongoing sustainability.
What kinds of savings can be made with currency hedging?
Avoid the temptation to ascertain what savings can be made. Think of currency hedging as a form of insurance rather than a potential income stream. Focus on what could happen if the risks aren't thought about and quantified. For example, consider whether your business could survive a 78 cent US exchange rate if you'd budgeted on selling in that market at 68 cents - meaning an extra US$100,000 would be needed to return the same NZ$1 million budgeted to cover costs and make a profit.
Doing the analysis ensures a "surprise" move (and they happen all the time - unsurprisingly!) is not life-threatening for the business. And bear in mind that a 10 cent currency move is nothing special - it's just normal volatility.
We have set up an office in the UK. What currency advantages can there be for us with a UK office?
When earning sterling, try to maximise the "natural" hedge by denominating as much of the expense side of the business in sterling as is practical. This has the added advantage of decreasing transactional costs around financial market hedging activity.
Consider whether raw materials can be sourced in sterling or travel expenses incurred in that currency. Accounting and IT functions can be outsourced to British suppliers.
There must, however, be a valid economic reason to pay sterling. It doesn't make sense to pay a lot more than you would pay locally to use up sterling receipts that can better be managed through hedging.
Where do small businesses go wrong when it comes to hedging currency? Are they too informal about it?
Businesses of all sizes typically go wrong in ignoring the risk because they don't realise that apparently wild currency fluctuations (for instance, plus or minus 20 per cent) are actually well within the normal currency fluctuation parameters.
Common mistakes also include believing one can foretell the future and predict currency market movements.
The reality is that nobody - not even the "experts" - knows what will happen next, so hope for the best but plan for the worst.
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