Currency Hedging Strategy: Find the Right Hedging Ratio for Your Business
The development of your currency hedging strategy begins with articulating your company’s attitude toward risk. Here are two critical questions to start your reflection:
Currency Hedging Strategy: Risk Reduction Objective
- Is your goal always to reduce risk to zero?
- Or is it to maximize opportunities by aiming for a better exchange rate, even if it means incurring costs in case of adverse movements?
Between these two extremes, a more comfortable position for your company can be identified. Ultimately, the real question is: to what degree do you want to benefit from favorable currency movements to increase your profit margins? Your currency hedging strategy should reflect this balance.
The key here lies in the phrase “to various degrees.” The more you seek to capitalize on favorable movements, the more exposed you will be to adverse ones.
What is the Hedging Ratio?
The hedging ratio measures the portion of your currency risk exposure that you choose to hedge. Determining the optimal ratio depends on your company’s risk tolerance.
Risk Tolerance
Your strategic objectives must align with your company’s risk tolerance. The more aggressive your goals, the higher your risk tolerance needs to be. Your currency hedging strategy will guide you toward the “degree” appropriate for your business.
Factors to Consider
Risk tolerance is a functional relationship between your company’s financial capacity to take risks and your willingness to do so. There is no right or wrong answer—only your answer.
When determining your risk tolerance, whether for currency or any other risk, consider:
- The level of control you have.
- The potential impact on your business.
- The probability of the risk materializing.
- The experience, expertise, time, and resources available for risk management.
For example, positive experiences and consistent efficiency in managing risk can build confidence in taking that risk. Access to capital can help absorb losses without significantly jeopardizing overall performance. Real-time data availability, its transformation into actionable information, and employee skills are critical factors influencing the “degree” of exposure to currency risks your company is willing to accept. These are all essential elements of an effective currency hedging strategy.
Currency Exchange Movements
Exchange rates are unpredictable and behave like random variables, leaving no room for control. Their potential impact on your company can be measured using the concept of risk range. On average, since 1991, the USDCAD rate fluctuates by 4 cents monthly, equating to CAD 40,000 per million in monthly U.S. revenue. A movement of this magnitude is highly probable.
Volatility can also be used as a measure of uncertainty. For instance, the Canadian dollar (CAD) against the U.S. dollar (USDCAD) has a historical annual volatility of +/- 8.2%, with a possible annual range of over CAD 21 cents. A tailored currency hedging strategy ensures your business is prepared for such fluctuations.
The resources and time you have for managing this risk must form the foundation of your decision regarding the “degree” of exposure, as currencies move rapidly and frequently, often with significant amplitudes. Businesses must prepare proactively rather than reactively.
Preparation and Risk Management
Currency markets are fast-moving, with significant amplitudes. Companies cannot afford to be reactive—they must be prepared. Do you have tools that synthesize and update all relevant information in one place? Such tools offer a clear view of performance variability sources and better control over the “degree” of variability your margins are exposed to.
It is essential to understand and define the level of risk your business can handle, the risk it is willing to tolerate, and, ultimately, the risk it wants to take.
Key Questions to Determine Your Hedging Ratio
To do so, here are three critical questions whose answers are unique to your business:
- What is your capacity to handle a loss?
The consistency of your revenue streams and your other liquidity sources form the basis of this capacity. - What is your willingness to tolerate risk?
This is a more emotional aspect. Reflect on the last time you managed a loss: how did you react? What is the maximum amount you are unwilling to exceed to achieve your goals, regardless of your capacity? - What do you stand to gain by accepting this risk?
Or, put differently, what are you willing to lose for the possibility of gaining $1?
In risk management, the only wrong answer is someone else’s!
Additional Resources
For more insights on currency hedging strategy, please consult the following articles:
- What is Currency Hedging
- Currency Hedging Strategy: Navigating Market Uncertainty
- “Currency Volatility: Understanding Risk Range”
- “Currency Volatility: How to Account for It in Risk Management”
- “Currency Risk for SMEs: How to Assess Hidden Budget Risks”
International Markets: A World of Opportunities
Expanding your business internationally offers growth potential but also risks for SMEs. Tracking the successive impacts of exchange rates on your company’s anticipated performance is complex.
D-Risk FX provides SMEs with performance analyses, risk assessments, and scenario testing by market, currency, and business line. This leads to a tailored hedging strategy and real-time tracking of your company’s anticipated performance.
Gain autonomy, automate your processes, and approach foreign markets confidently with a clear currency risk management strategy and monitoring aligned with your ambitions.
