with many businesses across all sectors suffering from the fluctuation in the euro and watching their profitability erode, it is important to recap on hedging, the process via which businesses can lessen the impact of unexpected currency moves on their bottom line. Without delving into the complex types of hedging, simply put, here is how it works.
Lebanese companies that engage in overseas trade, such as car and food importers, regularly face a problem that stems from importing products or services in a currency different than the base currency. Lebanese companies that import from countries using the euro face currency risks. The fluctuations in the euro can cause profit margins on the final items to fluctuate. If the company is hit with a sudden rise in the euro, it must absorb the change, and if it is unable to pass on the change to the consumer, it may end up with a net loss.
For companies that trade in large amounts annually, the changes can cause serious strains if not neutralized. We have all heard the anecdotal pretexts given by everyone down to the vegetable seller, that things are pricier, “because of the euro.” Simply put, unlike other Arab countries like Saudi Arabia, where the Toyota/Lexus agent carries out very complex hedging procedures to offset any sudden fluctuations in the yen, most Lebanese companies remain unhedged and pass on any increases to the consumer.
Companies who want to neutralize the effect of currency variations will typically sell an equivalent amount of foreign currency forward in order to lock in a specific rate and have clarity as to their upcoming results. They will for instance, if they are worried about a rise in the euro, buy euros forward to a specific date which covers the duration of their liabilities. This way, they have in a sense, taken care of their needs without having to worry about paying up more for their euros later on. Or if they have merchandise coming in, which was priced in euros to start with, they can do the same so that when they receive their goods, they can price them appropriately.
The raison d’etre of hedging came about with the assumption that the pricing of the final product ought not to be dictated by wide swings in exchange rates. Hence the process of hedging, the key to which is offsetting future risks by using the foreign exchange markets. When a company decides to tackle the currency element in its operations, it will typically look at its forecasted cash flows in currencies outside its base, and use tools to blunt, or lessen the effects of future movements. If the company has liabilities in euros for instance, or if it imports products in euros, it will look for ways to match those flows in a way that gives it visibility going forward. Of course, a company may decide to leave foreign exchange risks un-hedged, but then it would be taking a speculative view on currencies, an exercise that involves risk and risks can make or break its fortunes. More importantly, it would be over stepping its core operations, for it is not in the speculation business.
Recently, with the advent of very complex instruments, many multinationals have in fact engaged in speculations under the umbrella of hedging. Some have ended disastrously; such was the case of a large European conglomerate based in Germany, which had decided to go un-hedged on large contracts. So any business no matter how small can, in effect manage its currency exposure. A shop importing clothes from Milan as well as a large corporation face in essence, the same issues, but with varying degrees of scale and complexity.
But it is not just importers that face a currency dilemma. Companies that have overseas operations also face a currency decision which relates to the translation of its profit/loss accounts from overseas back into the base currency. The bottom line is that a proactive approach, with the assistance of a bank treasurer can help reduce the effect of currency swings on the operations of a company. While hedging techniques have developed, it is crucial for businesses to have a clear view of their upcoming liabilities to optimize the hedging process. The tools available range from straightforward contracts to complex options that are most often used by multinationals to offset complex transactions.
Hedging is a tool which enables companies to protect against changes in their base currencies, but it is also useable in a variety of other investment forms such as interest rate risks, equity crash risks as well as a range of commodities. It’s a smart move.