Prevent Under/Over Hedging Mistakes With Your Currency Requirements.
Over-hedging and under-hedging are common risks associated with currency volatility and can have negative impacts on a company's financial performance and competitiveness.
Although this concept primarily applies to businesses with economic currency exposure, companies facing transactional currency exposures may also opt to speculate on positions, leading to the creation of such risks.
Over-hedging
Over-hedging occurs when a business hedges more than its actual exposure to currency risk, resulting in a lack of flexibility and competitiveness.
Some of the problems associated with over-hedging are below.
Inability to reprice
Over-hedging in foreign exchange can make it difficult for businesses to reprice their products or services if exchange rates move significantly. This is because over-hedging can result in a mismatch between the hedging positions and the underlying exposures. As a result, this can lead to lost sales and reduced profitability.
Lack of competitiveness
A company may struggle to offer competitive prices to its customers should exchange rates move favourably. If the market moves in their favour, a business may not be able to benefit from the favourable exchange rate as they are already locked into a less favourable rate due to their over-hedging. This can result in their products or services becoming less competitive in their marketplace, and customers shopping elsewhere as the competitors that didn't over-hedge can offer similar products or services at a lower price.
Cashflow implications
Depending on the credit facility of the business, over-hedging may require the company to hold a larger amount of cash or collateral as security for the additional contracts. As a result, this can increase financing and cash flow implications due to the possibility of further deposits or margin calls.
Under-hedging
On the other hand, under-hedging occurs when a company hedges less than its actual exposure to currency risk, resulting in increased exposure to price movements and potential financial losses. Some of the problems associated with under-hedging are noted below.
Increased exposure to currency risk
When a company is capable of accurately forecasting its currency requirements but does not hedge its currency exposure adequately, it is essentially engaging in speculation on the direction of the currency markets, which can lead to increased risks. If exchange rates move unfavourably, the company may have to bear higher costs for purchasing goods and services from foreign suppliers, ultimately resulting in reduced profitability.
Difficulty in budgeting and forecasting
By not hedging enough, a company may not have a clear picture of their actual currency exposure, making it difficult to anticipate potential fluctuations in their expenses and revenues. This can lead to a lack of predictability in financial performance, which can make it challenging for companies to plan ahead.
Missed opportunities
When a business does not hedge its currency exposure adequately, it may miss out on the chance to benefit from favourable movements in exchange rates, leading to lost sales and a potential loss of competitiveness. This situation could arise due to the company's insufficient hedging strategy for protection against adverse currency movements or its limited hedging positions.
How to avoid the under/over hedging mistakes?
Companies can avoid both under-hedging and over-hedging by developing a comprehensive and customised hedging strategy that aligns with their business goals and risk tolerance. By doing so, businesses can minimise currency risk and protect their bottom line.
To avoid over-hedging, companies should break down their total currency exposure into smaller portions and can use methods such as hedging programs that contain a combination of spot contracts, forward contracts and options products. This can help businesses to create a buffer for negative currency movements while also enabling them to participate in new hedging contracts if the market moves favourably.
On the other hand, to avoid under-hedging, companies need to have a clear understanding of their currency exposure and potential risks. Companies with a high degree of FX exposure may opt for a more aggressive hedging strategy to reduce risk, while those with lower FX exposure may choose to be more conservative. It is also essential for companies to monitor their currency exposure regularly and adjust their hedging strategy accordingly to ensure that they are adequately hedged at all times.
Contact Us
At Centura FX, we specialise in creating customised hedging strategies to mitigate the risks of under or over-hedging. Our team can assess your current hedging practices and provide recommendations to ensure that your company is not exposed to unnecessary risk or missed opportunities. With our expertise, we can help you avoid financial setbacks and achieve your goals.
Contact us today by arranging a call with one of our specialists or you call us directly on 0203 871 9830.