For currency markets, it seems like volatility and uncertainty is the new normal. Between the Swiss Franc crash last year, the Brexit-sparked 12 per cent fall in the GBP over a single afternoon and even the NZD's flash crash in late August 2015, we're peering around corners looking for the next event to derail the global economy.

For New Zealand businesses, this means you need a prudent approach to foreign exchange risk management if you're going to get anywhere. According to Phillip Lindberg, Foreign Exchange Manager at OM Financial, hedging your FX could be one way to save the day.

Why should companies even consider hedging?

"If you are lucky enough to operate in a market where you can pass through any costs to your consumers, then you probably do not need to consider hedging," Lindberg says, adding that companies with a product that moves in line with the exchange rate might also be able to avoid hedging.

"However, if you operate in a market with competitors that have a hedging strategy and you do not, it could potentially put you at a competitive disadvantage if your bottom line is being eroded by the value of the NZD."

"Whether you are an exporter that is distributing products into international markets, or a manufacturer that imports materials for production, the value of the NZD can wreak havoc on your bottom line."

Recently, the value of the NZD has meant that importers have performed well, while exporters have felt the pinch. Even though it has been relatively stable in 2016, Lindberg notes that when you're on the wrong side of a 15 per cent range, it's going to be painful. However, it is possible to take advantage of New Zealand's current status as an appealing investment option to make a significant benefit to your business' bottom line.

"Where companies or individuals often get it wrong is by how they strategically approach their business management," Lindberg says.

"The issue should be 'how' to hedge, as opposed to 'should' I hedge."

Common hedging mistakes among New Zealand businesses

A common approach to hedging is by using forward exchange contracts that allow you to lock in a price today for conversion at a future date. However, Lindberg notes that many companies don't do this the right way.

"The mistake that is often made is preferring the use of forward foreign exchange contracts for 100 per cent of your exposure.

The hedging approach of using only forward contracts can expose a company to a number of risks: if orders get cancelled, or product is lower than forecast, or the price of the underlying fluctuates from that assumed, then there is the potential to leave the company in a position of being over-covered."

When this happens, the company is either forced to close their foreign exchange positions out at current market rates or roll their positions - potentially at a loss - forward to a future date. Either outcome is less than desirable."

Another approach to managing foreign exchange is the 'do nothing' approach, whereby companies only exchange currency at market rates.

"This exposes the company to all the vagaries of the markets," Lindberg explains.
"Interestingly enough, both of these approaches are often cited by companies who say they do not want to take a view on the market. It is difficult to see a more aggressive market view than locking in your entire FX risk through forwards, or putting your head in the sand and hoping."

So if these open up your risk, what is the right way to hedge? "

"A more balanced approach to hedging is starting with a risk neutral stance of being 50 per cent hedged, and 50 per cent unhedged. From that point you can build a hedging strategy that combines forward foreign exchange contracts and foreign exchange options to provide surety, but also allow flexibility to benefit from future foreign exchange moves."

Having been involved in foreign exchange markets globally for the past 30 years, Lindberg is still surprised by people's aversion to using foreign exchange options because they are deemed too expensive.

"We are conditioned to paying premiums to insure our houses, our cars, and even our health. For most of us, at the end of each year we thank our lucky stars we haven't needed that insurance and we happily pay our premiums again for the following year.

Foreign exchange risk should be no different, and when combined with traditional hedging techniques, can provide a flexible way to protect and enhance cash flows."

In times of volatility, it is important to be able to protect your bottom line and keep the business growing. Hedging FX - done the right way - can set you on the path to financial stability, no matter what happens in global currency markets.

For more information click here