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Hedging Your Currency Bets

Tax and Finance

An article appeared in the New Zealand Herald a few months ago which examined the currency hedging practices of Kiwi exporters. The conclusion seemed to be "damned if you do, damned if you don't". We asked our good friends at the HSBC what they thought and what tips they might have for exporters that are considering currency hedging.

1. How do interest rate movements affect New Zealand’s trade with China?

Interest rate movements in New Zealand can have an impact on the New Zealand dollar. Foreign investors who chase yield have previously driven up the NZD in what is known as the carry trade. The carry trade is where investors borrow low-yielding currencies and selling these currencies to invest in high-yielding currencies, gains can come from both an appreciating currency and increased interest income. This was one of the factors that saw the NZD trade above 0.8000 cents in 2007 / 2008.

Exporters who trade with China and sell their goods in US dollars may become uncompetitive at these very high currency levels. This is only one side of the story as a higher currency may be offset by higher prices for the goods that are traded. So there are more factors to take into account outside of the currency.

2. How would you rate Kiwi businesses understanding of and execution of exchange rate risk management?

Due to New Zealand’s geographic isolation we are a trading nation buying and selling many products and services in the international markets. This along with a relatively free market economy means many of our larger companies have a very good understanding of exchange rate risk management. For many smaller companies and new entrants to exporting and importing this may be a daunting task. Most quickly gain an understanding of exchange rate management through experience and by using the knowledge available through their Bank’s Treasury operation.

3. What are some of the common challenges facing Kiwi exporters who want to hedge against their exposure to exchange rate fluctuations?

The number 1 issue facing Kiwi exporters is the volatility in the New Zealand dollar. In 2009 the New Zealand dollar traded a range of 0.4895 to 0.7635 and our trade weighted index (a measure of the value of the New Zealand dollar relative to the currencies of New Zealand’s major trading partners) traded 50.66 to 67.99.

Another major issue is dealing into countries that have restricted convertibility of their currency this may result in forward hedging having to be done using the offshore USD–settled, non-deliverable markets. The Chinese renminbi (CNY) is one such currency that maintains a managed float. The currency is managed by the People’s Bank of China (PBOC) - China’s central bank. The renminbi is non-deliverable and partially convertible. The market for the CNY has been undergoing gradual liberalisation and HSBC provides pricing for both on-shore spot and forward market and off-shore in the non-deliverable forward market.

4. What advice do you have for exporters who want to reduce the risks associated with currency fluctuations?

All business that trade overseas are likely to be exposed to foreign exchange risk arising from volatility in the currency markets. The most common cause of foreign exchange exposure arises from having to pay invoices for imported materials priced in foreign currency or receiving foreign currency for your exported finished goods. For many business, the impact of exchange rate volatility can be significant.

Managing Foreign exchange risk does not have to be complicated. HSBC advocates the use of the following four- point plan. This simple plan lays the foundations for the management of your foreign exchange exposures :

•    Understand your exposures

•    Understand hedging products

•    Develop a strategy

•    Implement it

Point 1 - Understand Your Exposures

There is a raft of factors to take into account when assessing your exposure to foreign exchange rate risk, for example:

•    What proportion of your business relates to imports or exports?

•    What currencies are involved?

•    What are the timings of payments?

•    What impact would an adverse rate movement have on your profitability?

•    Is the level of overseas business likely to change?

•    Do you pay and receive in the same foreign currency - it may be possible to mitigate the exchange risk by using a foreign currency bank account?

Point 2 - Understand the Products

There are only three basic alternative methods to manage foreign exchange risk.

•    Do nothing and buy or sell your currency in the spot market.

You act on the day you want to buy or sell your foreign currency. Whilst simple, this approach means you will not know how much New Zealand dollars you will need to pay or receive for your foreign currency until the day in question - this can be a high risk strategy as the exchange rate may have moved significantly since you agreed the price with your customer/supplier. If rates have moved the wrong way, your profit will be reduced accordingly.

•    Lock in to fixed rates - as soon as you become aware of a need to exchange foreign currency at a future date, you can fix the exchange rate by booking a forward contract. This approach provides certainty but you could suffer an opportunity loss if rates subsequently move in your favour and you are obliged to transact at the forward contract rate.

•    Use flexible products - a currency option will offer you the potential for upside benefit if rates move in your favour - like a spot deal, but will provide protection against adverse rate movements - like a forward contract. For this flexibility you will need to pay a premium although there are zero cost option products available where an up front premium is not required.

Point 3 - Develop a Strategy

It may not always be best to adopt any one of the three alternatives in isolation to manage your foreign exchange risk. Many businesses, reflecting their attitude to risk, their view of the currency markets, preparedness to pay premiums and a host of other factors, will adopt a portfolio approach - using a combination of spot, forward exchange contracts and currency options, HSBC works with there customers to develop a strategy that best meets the requirements of your business. For example in an uncertain exchange rate environment, you may decide to transact 25 per cent of your currency in spot, fix 25 per cent with a forward contract and cover 50 per cent with flexible solutions such as an option. This way, if rates move in your favour, you will benefit on 75 per cent of your exposure (spot and options) whilst if rates move against you, you are protected on 75 per cent (forward contracts and options). This is a balanced approach that provides flexibility, and avoids you paying a premium for all of your protection.

Point 4 - Implement it

It is often tempting to defer a decision to implement your foreign exchange risk management strategy, perhaps in the hope that rates may move in your favour in the short term. Historically, currency markets have been extremely volatile and unpredictable - it makes sense therefore, once you have formulated a strategy, to implement it without delay and ensure your profits are protected.

The information in this publication does not constitute an invitation, offer or recommendation to subscribe for or purchase any security, product, or service, nor does it contain investment recommendations or advice. The information and views are of a general nature and do not take into account your personal objectives, financial situation and needs. You should seek independent professional advice before making any investment decision. Neither HSBC nor any person associated with this publication accepts any liability for any loss or damage whatsoever that may directly or indirectly result from any, opinion, information, representation or omission, whether negligent or otherwise, contained in this publication.