Hedging your bets: how SMEs can manage currency risk

The UK is scheduled to leave the European Union on March 29th next. Continued uncertainty on the prospects for a Brexit deal is causing major volatility on currency markets, in particular with the sterling/euro (GBP/EUR) exchange rate.

Prior to the Brexit vote, sterling was trading at €1.30. In the past six months, the average rate has been about £1/€1.12, close to post-2008 crisis lows.

Weak sterling is a major concern for Irish companies exporting their goods and services to the UK, including Northern Ireland. The total value of Irish goods destined for the UK in 2017 was €14 billion (or 11.5 per cent of total exports). The UK remains Ireland’s single largest trading partner for the agrifood sector which exported €5.2 billion worth of goods to Britain last year. That leaves the sector highly exposed to currency risk (the risk that exchange rate movements affect your business’ costs and revenues, impacting cash flows and eroding profit margins.)

Sterling's depreciation has devastated the Irish mushroom industry, forcing many producers out of business. The casualties include McDonald Mushrooms in Tipperary, which reportedly lost an average of €11,000 a week from adverse currency movements.

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In contrast, Irish importers have been enjoying a “Brexit boom” – evidenced in the construction and automotive industries – as spending on “bargain” imports from Britain has soared since 2017.

Managing currency risk

So what can businesses exposed to currency fluctuations do?

The focus for these businesses is to employ currency risk management strategies to reduce the volatility of their cash flows and protect underlying business margins.

When implementing a hedging strategy, the business needs to review costs denominated in foreign currency (foreign currency payables) and revenues (foreign currency receivables).

Irish firms making foreign currency payments aim to minimise the euro cost of foreign currency payables and protect against an appreciation of the currency of that payable. Irish firms receiving foreign currency payments aim to maximise the euro proceeds of the foreign currency receivables and protect against a depreciation of the currency of that receivable.

A basic cost-effective hedging strategy is to ask international suppliers for a dual invoice. This means that two prices are quoted for goods purchased abroad – one price in euro and one in the domestic currency of the supplier. Companies can compare the costs based on the exchange rate differences and then choose the cheaper payment method on the due date.

Alternatively, firms can manage currency risk by using operational and financial hedging tools – such as forwards, options and swaps. But what are these?

Forward contract: a forward contract is one of the most widely used financial hedging instruments. It is an agreement with the bank that locks in an exchange rate for the purchase or sale of a specified amount of foreign currency on a future date. That mitigates exposure to adverse movements in the exchange rate from the date the contract is entered into. The flip side is that there is no opportunity for companies to benefit from favourable exchange rate movements in that period.

Currency options: A vanilla option is the equivalent of an insurance policy. In return for paying an up-front premium, the holder of the option has the right but not the obligation, to buy or sell one currency against another currency for an agreed price (strike price) on an agreed future date. Option contacts limit downside risk by locking in the strike price but they also allow companies to benefit from unlimited upside potential.

Currency swaps: A currency swap is an agreement in which two parties exchange the principal amount of a loan and the interest in one currency for the principal and interest in another currency. Companies enter into currency swaps to hedge a long-term borrowing commitment dominated in a foreign currency.

Operational hedging: Research has shown that an effective risk-management programme combines financial and operational hedging. Operational or "natural" hedging involves changing the firm's real physical operations to reduce overall foreign exchange exposure. It is a critical element in the management of longer-term exposures.

As most derivative contracts are short-term, firms also need to use longer-term hedging techniques. Operational hedging is particularly useful for firms that find it difficult to predict future foreign currency cash flows. Operational hedging enables companies to match foreign currency revenues with costs in the same currency.

In response to sterling's weakness, Irish producer Codd Mushrooms Ltd plans to expand operations into the UK to avail of lower production costs. Similarly, Kepak Group, one of Ireland's largest meat processors, has acquired four production sites in Britain. These operational moves offset sterling costs and revenues thus mitigating currency exposure.

To hedge or not to hedge

The decision to hedge is dependent on a number of factors including the business’ risk appetite, treasury policy, long-term contract commitments, supplier payment cycles and underlying business margins. Company boards should be proactive in establishing risk management committees to regularly assess and review risks exposures.

Dr Elaine Laing is an assistant professor in finance and director of the global business (BBS) programme.