International companies, how to choose your foreign currency hedging?
If your company is operating outside of SEPA, buying and selling worldwide, you need to take into account variations in the exchange rates of the currencies you deal with. To avoid bad surprises, it is wise to use foreign currency hedging techniques. What is foreign currency hedging? What is it, how to choose it?
Why should you use foreign currency hedging?
When you carry out transactions in a different currency from yours, foreign currency hedging is a financial protection used to protect your company from the exchange rates variation. Its purpose is to protect against potential losses or to lock in the exchange rate between two currencies, thus allowing you to:
- Protect your commercial profits
- Protect your company’s and your products’ competitiveness
You can choose in-house hedging techniques (set up by your treasurer).
Or, you can choose hedging products (from banks) to protect yourself against foreign exchange risk.
The different foreign currency hedging techniques, which one to choose?
There are different foreign currency hedging techniques. The currency hedging’s choice and degree will depend on the security required for your transactions and their final profitability. Do they require a reduced or totally eliminated foreign exchange risk? Or what will be the final cost impact of hedging on your cash flow? These questions will help you to decide.
To determine which hedging technique is the most adapted, it is necessary to know the type, the origin and the deadline of your future cash flows. It will also be interesting to look at the currency position on a currency-by-currency basis and thus determine, depending on the type of transaction, which exchange rate policy should be applied.
Depending on your needs (frequent or occasional, simple or complex), you can combine several techniques.
1. In-house hedging techniques
First, it is possible to manage your foreign exchange risk by setting up in-house foreign currency hedging techniques. The implementation of these techniques depends on your company’s objectives and financial situation.
Choosing to buy and sell only in the same currency
You can choose to make transactions only in your currency (EUR for example), or only with SEPA countries for example. In this case, the transactions will be made only in euros, so you will not be exposed to the exchange rate risk.
It is possible to limit the exchange rate risk by compensating your incomes and expenses in the same currency. This means that the payment in a foreign currency will be applied to the payment of a debt denominated in the same currency.
If you wish to use this technique, you must first ensure that you have a rigorous management of your foreign exchange positions and a balance between your receivables and payables denominated in the same foreign currency.
Leads and Lags
This technique consists of delaying your payment dates in order to take advantage of favorable exchange rate trends. Concretely, the goal is to try to accelerate or delay your company’s incomes and expenses according to the anticipated increase or decrease of the exchange rate.
Escalation clauses can be fixed in a contract between your company and a customer.
An escalation clause provides for a value variation in the contract, in this case the price, according to the variation of an element external to the contract, the exchange rate.
Including an escalation clause in a contract protects against a sudden increase or decrease in the currency exchange rate. This type of contract transfers a part of the risk to the buyer, which is why its implementation often requires a long negotiation period and is rarely accepted.
2. Foreign banking and currency hedging products
If you have a high and recurring protection need, you have to use foreign currency hedging with a banking institution to be more secure.
The cost of this type of protection can depend on the contract type, and also on the banking organization you choose. Different products are possible:
If you choose this product, it will allow you to exchange currencies at a negotiated rate on a fixed date, usually two days after the negotiation with the bank.
By choosing this option, you lock in the rate at which you will buy the required currency. You are protected against a potential increase in the exchange rate of this currency.
It allows you to lock in a transaction exchange rate at a fixed date. An agreement is made between the bank and your company for a specific purchase or sale of currency. The exchange rate to which the bank commits itself will remain fixed regardless of the actual exchange rate value at the due date. With this solution, you secure your margin at 100%, but you will not be able to make a profit if the exchange rate undergoes a favorable variation.
It is possible to ask your bank for a currency advance.
For example, if your company operates in a SEPA country and needs to collect an invoice in USD in 90 days, the bank will send your invoice amount by converting the USD into EUR. You reimburse this credit on the payment receipt date from your foreign customer at an interest rate fixed in advance.
The currency advance is particularly interesting if your foreign customer pays you in foreign currency with a deferred payment (30, 60, 90 days…). It allows you to anticipate the invoice payment and to prevent a variation of the exchange rates which could reduce your profits at the collection date.
A Swap is the exchange of one currency for another, and then the exchange in the opposite direction at a later date fixed in advance.
It is a reciprocal credit agreement between you and your bank: there will be a purchase/sale at a fixed date, then a sale/purchase at a later date of the same amount but in the opposite direction. This allows to combine two foreign exchange transactions simultaneously, spot and forward, on defined dates and at predetermined rates.
Vanilla option (Call or Put)
Buying one of these options gives you the opportunity (not the obligation) to buy (Call) or sell (Put) a currency at a fixed, pre-negotiated rate until a specified time, in exchange for a premium payment.
If you have, for example, purchased a Call option, in the event that the currency price increases significantly, you will be able to make a profit. On the other hand, if the opposite occurs, you can exercise your option and thus protect yourself against a significant decrease in the exchange rate.
Tunnel option (Call and Put)
Tunnel option is a combination of buying a Call option and selling a Put option. With this type of foreign exchange product, you are guaranteed the maximum price at which you will buy your forward currency, but you also limit the minimum price at which you can buy it.
Optimize your foreign exchange risk management with Allmybanks
- Automatically integrates the exchange rates
- Allows you to enter the committed and optional foreign currency hedging products
- Automatically generates the corresponding forecasts in your treasury forecast plan
- Displays in a table with advanced features their performance over time
Thanks to Allmybanks, you can easily analyze and manage the impact of foreign currency hedging on your treasury!