The key elements of an effective hedging programme

Finance & Funding

Key learnings

Currency fluctuations are driven by geopolitical, economic, and global factors, affecting businesses in international trade.
A solid FX hedging programme helps mitigate currency risk, ensuring financial stability in volatile markets.
Effective hedging requires clear objectives, understanding risk, and continuous monitoring to adapt to market changes.

Foreign exchange markets are volatile, influenced by factors like geopolitical tensions and economic shifts, which can pose significant risks to businesses. To mitigate these risks, companies need a well-structured FX hedging programme that protects against currency fluctuations and ensures financial stability. In this article, UMi partner Convera outlines the key components of an effective hedging strategy, including clear objectives, risk understanding, and regular reviews to adapt to market changes.

When currency risk is high, enterprises need to be aware of their exposure and develop, implement and manage a clear, thorough plan to navigate these challenging times. Effective hedging programmes should no longer be a luxury; they are a necessity amid increased uncertainty.

Why do you need a hedging programme?

Global currencies constantly fluctuate, and any organisation that trades across borders, accepts payments in foreign currencies or holds financial assets abroad should consider implementing an FX hedging strategy.

Unfavourable shifts in global conditions can result in sudden losses that could damage an organisation’s growth goals and take years to recover from. A good hedging programme can protect an organisation against these shifts by reducing risk through market and currency fluctuations using various financial instruments, but it has to be done right as there are also risks involved with trading financial instruments.

Three components of a good hedging strategy

While FX hedging programmes are essential in times of high volatility, they’re not a simple solution. Foreign exchange hedging requires a solid understanding of complex financial concepts and comes with potential downsides, when not thought through.

Solid objectives and a clear action plan

Organisations must ensure they’ve outlined their objectives clearly and follow a disciplined plan that considers both their future needs and their immediate goals.

These are some questions to keep in mind:

What do you hope to achieve through your hedging programme?
What are your business needs?
What are your underlying FX exposures?
Do you have a solid understanding of your company’s financial health?
What do the cash flows look like?

Regardless of your goals, a clear long-term plan based on data will help you stay on track.

“First and foremost, develop a plan,” explains David Renta, Global Head of Hedging at Convera.

“Too many times in the past I have seen companies that have struggled with getting data around what their underlying exposures are, and when they develop a plan and then they can’t stick to it.”

In order to avoid this, David advises to partner with experts, who can help understand those exposures and develop a hedging programme, together.

“Then, once you get that set out, make sure to give yourself enough flexibility not to miss opportunities but also, stick to the plan.”

A firm understanding of risk

Hedging is designed to protect an organisation against financial risk, but no strategy is foolproof.

Some hedging programmes can incur high administrative and automation costs. Some strategies, especially those that depend heavily on speculation, will inherently expose an organisation to more risk, including the potential for an adverse event.

A solid risk management strategy can help offset potential losses. Leveraging their own resources and knowledgeable partners, enterprise leaders should examine their risk tolerance and move forward with a clear-eyed awareness of what they’re taking on.

David says: “When a company is essentially forecasting transactions that they have underlying exposures with and something fundamentally changes from those underlying assumptions, it means a company has to find a financial partner that can both understand the underlying drivers for why those changes are taking place and employ strategies that actually marry up with what their underlying exposures look like, post the disruption.”

Regular review

Hedging is designed to help organisations better cope with currency fluctuations, so as global conditions change, hedging strategies should be reviewed and adapted to ensure adherence to long and short-term goals and changing business needs.

“The key takeaway is when you’re working internationally, you need to partner with someone who understands the market dynamics and can offer you the flexibility to ensure that your hedges and your underlying exposures are measured,” David says.

How to develop and manage a hedging strategy

In developing, implementing and managing a hedging strategy, organisations should consider their short-term goals alongside their long-term business needs.

Hedging strategies typically involve a few key moving parts.

Consider the hedging lifecycle

The FX hedging lifecycle involves various stages, from planning to execution to review.

Traditionally, an FX hedging strategy starts with a planning phase. This is the time to calculate a risk value and whether this value can change depending on external conditions (such as a political or economic upheaval).

Once everything is planned out and risks are managed, it’s time for the next stage. With a well-thought-out strategy and clear objectives, executing the trades is meant to be the easiest step.

Reviewing what worked well and optimising for potential misses is the final phase, before the FX hedging lifecycle repeats.

Identify specific vulnerabilities

These might include transactional exposures (cash flow); translation exposure through balance sheet items like foreign cash balance, inventory, fixed-rate loans or bonds; net equity in foreign subsidiaries; firm commitments; and your net investment exposure, all of which are tied to an underlying asset.

Depending on the balance of business holdings and particular investments, organisations should be able to identify their big-picture vulnerabilities as well as individual touchpoints that need attention.

Then, regulatory complexity and lack of consistency across different markets pose significant challenges, a task even more difficult without a knowledgeable partner.

“It’s a complex undertaking that requires horizon scanning and a true army of people to make sure that you’ve got proper subject matter expertise to ensure that you’re doing what you’re supposed to be doing as it relates to each of the regulatory regimes where you operate,” David explains.

Account for key stakeholders and communication needs

Hedging programmes can impact a variety of stakeholders in an organisation, including accounting departments, legal teams, technical staff, financial planning teams and more.

Ensuring that all stakeholders understand the goals and expectations of the FX hedging program and receive consistent, clear communication as it evolves is essential to the success of a hedging program, especially when using complex financial tools like options and futures contracts.

Weigh the costs

Hedging can incur significant costs, from additional administrative fees to lower-than-expected portfolio growth over the long term.

An organisation should consider costs and risks alongside any potential benefits of a hedging programme.

The timeless key to a successful FX hedging strategy

Like any major financial decision, whether or not an organisation decides to implement a hedging strategy to protect against currency risk, and how to implement that programme, will come down to a complex set of considerations based on its individual goals, needs and risk tolerance.

A solid awareness of risk, clearly defined goals and a well-thought-out plan are the first steps to building a hedging programme that can maintain an organisation’s financial health in times of uncertainty and offer essential portfolio protection.

Partners, like Convera, can help develop, implement and manage an effective hedging programme. Starting with a suitability assessment, Convera’s hedging experts consider financial knowledge and experience, financial conditions, risk tolerance and goals and objectives for each client. Convera then helps you tailor a hedging portfolio based on what you’re looking to achieve and what’s really suitable for you based on your financial markets experience and where you’re hoping to get to.

Next steps...

Assess your business's exposure to currency risk and the need for a hedging strategy.
Develop a hedging plan with clear goals and a focus on risk management.
Get a free 30-minute FX health check with Convera to tailor and adapt your strategy based on market shifts.