Businesses Look to Hedge in the Face of Rising Currency Volatility

By Lucy Lillicrap, FX Risk Management Solutions, AFEX

AFEX recently launched its second annual AFEX Currency Risk Outlook Survey. The results reveal a picture of UK SMEs that are more internationally focused this year than they were last year but that are, in the face of volatile markets, approaching international trade with caution.

Nearly half the UK-based respondents (46%) in the survey of more than 450 financial decision makers at SMEs globally, said they expected to increase their international trade levels in the year ahead. This is up from just 26% in 2014. By contrast, only around one in 10 (12%) plan to reduce their level of international trade.

However, there also seems to be increasing recognition among these businesses of the impact global market and political events can have on their international ambitions. In this year’s survey, finding the right suppliers and customers (31%) was replaced by currency risk (43%) as the number one challenge facing businesses when it comes to trading internationally. The proportion of people citing this has increased from 32% when we first conducted our survey in early 2014.

This attitude broadly reflects the behaviour of world markets over the period. Between 2013 and the middle of 2014, foreign exchange markets were relatively benign but in the last 12-18 months, that’s all changed with nowhere seemingly left unaffected by currency volatility. There was the Greek debt crisis which sent the euro tumbling, the currencies of Australia, Canada, South Africa and New Zealand have been hit by weakening global demand for commodities and even last year’s Scottish independence vote saw volatility in sterling against the dollar rise to its highest level since 2008. In the last couple of weeks – outside of the polling period for our survey – we’ve seen the People’s Bank of China step in to devalue the Yuan on a number of occasions, creating yet more currency volatility and reigniting discussions about the prospects of a ‘currency war’. This action, which has been interpreted by many as a signal of a weakening picture for the world’s second largest economy, reverberated on stock markets across the world.

The effects of this have not been confined to blue chip multinationals; any company that either buys or sells goods in a currency different to their own will have been made acutely aware of the effect currency fluctuations can have on their top and bottom lines. Our research shows that 6% of firms have attributed an increase in the size of their business in the last 12 months to currency volatility and 4% say it has enabled them to accelerate their growth plans. Others have been less fortunate, with 8% saying they’ve had to close an office, reduce the size of their business, lower staffing levels or cancel growth plans.

It is therefore unsurprising to find that many businesses, against this backdrop, are looking to take a more proactive approach to managing their currency risk. Currently, two-thirds (66%) of the UK SMEs surveyed do not employ hedging tools – such as Forward Contracts or Options – but this looks set to change. Some 83% of respondents plan to employ some kind of strategy to mitigate currency risk this year and only 5% of companies plan to utilise risk mitigation strategies less this year than they did last year.

The most popular form of hedging, which 52% of SMEs look set to use, is the Forward Contract. This is an agreement to buy a set amount of a currency at a certain rate at a certain point in the future. These are typically aligned with large, confirmed orders and provide certainty that the price they’ve agreed will be the price they end up paying. This should form part of the normal planning and budgeting process for large transactions. Because the price is locked-in, firms won’t face the prospect, for example, of having to find more cash than they’d allowed for for essential goods they’ve ordered from overseas, because the value of sterling has fallen.

De-risking transactions should be the number one aim for businesses when it comes to doing business in foreign currencies and Forward Contracts are an excellent way to do this.

More sophisticated businesses that want to retain some flexibility and take advantage of potential upside in return for paying a premium,can use currency options. As the name suggests, businesses have the option, rather than obligation, to buy a currency at a certain rate in the future. Only 3% of those surveyed plan to use Options but they can be useful when used in conjunction with Forward Contracts.

Also popular with those businesses surveyed is to pass on the currency risk to their customers and/or suppliers, with 26% of respondents saying they plan to adopt this as a strategy. Avoiding foreign exchange entirely is certainly an effective way to de-risk international business from currency volatility, but the reality for most businesses will be that they have limited pricing flexibility in all their markets. Even where the currency risk is passed on to a third party, it just moves it elsewhere in the supply chain and volatility therefore still has the potential to make its impact felt.

Global markets are more interconnected than ever before, as the current response to events in China on world stock markets has served to remind us. Currency volatility is part and parcel of this international marketplace and businesses of all sizes across the world have felt its effects over recent months. In response, as our research shows, there is a growing awareness among small and mid-sized businesses of the need to hedge their FX exposure, which is to be welcomed and encouraged. The key principles to remember are: know your currency exposure; hedge that exposure using the appropriate tools based on the best advice; and, take a long-term perspective that gives you the certainty and confidence to focus on running your business.