Foreign Exchange - Don’t Neglect Additional Costs
Let's say you are going to be shipping metal from Europe to Asia on a long-term basis next year and currently your logistics costs are being quoted at EUR150/MT. If you don't take any hedging action on the EUR/USD and that exchange rate changes it can impact your profits. Using today's rate of ~1.0765, those costs translate to a USD cost of $161/mt. However, if the EUR were to appreciate against the USD to a rate of 1.10, you would now be paying the equivalent of $165/mt. Even a $4/mt change is an unnecessary risk to take when you have the option of locking in FX rates through hedging.
Looking further back, the same indecision at the end of 2023 would have resulted in a much larger loss. As you can see from this 5-year EUR/USD chart, in October 2023 the EUR/USD rate was around parity, but by mid 2024 it had appreciated to 1.12.
5-year EUR/USD Chart
Instead of an expected USD equivalent of $150/mt seen in October 2023, the logistics costs would have been $168/mt, an increase of $18/mt. Multiply that over an entire book of business and it would have a significant negative impact on expected profits.
Foreign exchange risks are not limited to direct costs linked to the purchase or sale of the commodities either. Indirect costs such as salaries and other overheads should also be taken into account when looking forward at these risks. Let's say that a US trading firm has offices in the UK. They would face additional costs that were not in USD. Let's say that their overheads for their UK office were GBP5m. In November of 2023 - when a company might be looking at their budget and targets for the following year - that would have converted to a USD cost of $6.1m with a rate of 1.22. However, comparing that to today's rates near 1.30, that same GBP5m in overheads would be costing them $6.5m, an increase of $400k. The larger the foreign currency exposure, the larger the risk to profits. Exactly how a company hedges their FX risks, the timing, and even how much of the exposure they hedge will often come down to their management's approach/understanding of risk, and whether they have a view on rates. As always with hedging, if the rate actually moves in your favor (in this example if the GBP/USD rate had depreciated), the overheads would have cost the company less in USD than in Nov 2023. But given the plethora of ways companies can mitigate FX risk, it is prudent to at least understand them fully even if they then decide against hedging.
For companies that do decide to hedge their forward FX exposures, there is the forward curve to consider. Much in the same way that we trade different prompt dates for outright metals hedging, there are different value dates (settlement dates) for foreign currency trades. If you are buying GBP and selling USD and you need the funds for 2 days time, you are going to receive a different rate than if you need a settlement date 1 month/3 months/6 months in the futures. The difference in rates between dates in foreign exchange is called points. A negative forward rate means that you will receive a lower rate in the future vs. spot rates, and vice versa for a positive forward rate. The forward curve for FX rates is largely dictated by the difference in interest rates between the two countries and the market's view on those interest rates. These forward rates can be fairly stable when looking at countries with similar central bank policies, or volatile when comparing currencies that have very different monetary policy. For example, at the time of publishing, the GBP/USD forward rate curve is very flat, largely because both the USA and Great Britain have similar interest rates and are both in rate cutting cycles. The current points for a 1-month GBP/USD position is around -0.750, and for a 1-year forward it is only -1.6. However, when you look at the current EUR/USD forward curve on a 1-month position it is +13.75 and for a 1-year forward it is +206. These differences in settlement dates depending on when you need to buy or sell currency are vital to take into account when executing hedges as they will impact the relative value you will receive. This is not to say that forward points negate the impact of hedging, but it is another factor you must understand when setting hedging procedures.
Some companies believe that because their costs in a foreign currency are the same as their income in a foreign currency they do not have an exposure, but this is also a misunderstanding of risk. Let's say that a company receives net income from their trading activities of 12m EUR, once in July and once in December. They also face overheads of 1m EUR per month January through December. So they expect that their inflows in EUR will exactly equal their outflows and hence they have no need for hedging. However, they will need to purchase Euros every month in order to pay their overheads, which will then be reimbursed when they receive the income from their trades. If at the end of each preceding year they entered into forward hedges whereby they bought 1m EUR each month Jan-December, and sold 6m EUR in July and December, they would no longer be exposed to any currency fluctuations. However, if they take no hedging action, they will simply pay, or receive whatever USD from the EUR/USD rate at the time of their transactions. FX rates can fluctuate wildly month over month and year over year. Being able to plan ahead with fixed numbers is often extremely beneficial to companies. It is true that the rates they pay or receive each month may actually be better than the rates when they executed hedges at the end of each preceding year - however they could just as easily be worse. The point of hedging is to mitigate these unknown risks and no longer have profits impacted by future movements in prices. While monitoring these cash flows does take some commitment, I would argue it is worth the additional effort and planning, particularly when the alternative means leaving yourself completely exposed to rates that you have no control over. Especially when they may have a significant negative impact to your profits.
I often hear from companies that they don't have a need to hedge their foreign exchange exposure. This could be because they lack the knowledge to do so, or they genuinely believe that they don't face an exposure. However, if your company transacts in any currency other than their own, it is incumbent upon them to at least understand that they do in fact face an exposure and what the ramifications of not hedging are. Armed with this information they can then make a much more informed decision.
