With the market uncertainty, risk management has always been a major concern for the corporate world. CFOs and finance managers go through sleepless nights in trying to manage risks and face challenges and decisions on daily basis since no one knows in reality where the markets are heading. Thus in order to avoid such frightening situations, businesses adopts a hedging strategy to create certainty in future cashflows from fluctuating foreign exchange that impacts the value of overseas payables or receivables. A company has to take into consideration various reasons whether to hedge or not to hedge. The reasons why a company may decide not to hedge are firstly because the currency of that country in which the company is operating may have a natural hedge (as in case of USD) or in case of internal payments i.e. directions received from overseas head office to not to hedge.
One of the reason why a company hedges is that it enables to maintain its profit margins against the future pricing of goods. Thus it helps avoid the uncertainty about the cost of imported goods against the budgeted costs due to exchange rate fluctuation. Also the decision makers do not have to worry about markets and can thus focus on strategies on efficiency and increasing sales which generate profits.
Taking a decision to implement hedging strategy is often a challenge. It depends on many factors such as the attitude of financial decision makers, nature of business, profit margins, etc. The decision making should be based on the budgeted costs. Foreign exchange rate fluctuations generally have a bigger impact on businesses operating on low profit margins. A high gross profit margin generally provides more flexibility. Also the opportunity costs of hedging should also be considered. A company can decide to hedge or not to hedge depending on its risk appetite.
Deciding on what hedging product to use is also important. There are many alternatives available in the financial markets which could make decision making difficult. The trick is to stick to basics i.e the level of protection and participation in financial markets. For example, a forward exchange contract can ensure full protection against exchange fluctuations but if the market moves in your favour it will not ensure participation benefits. On the other hand, an option can enable market participation but may not necessarily ensure full protection.
There is no perfect way of hedging or managing forex risks. So the basic things to remember is that the decisions should be majorly driven by business goals and markets. Choosing a strategy which can bring most favourable outcome is not complicated. Adopting a simple approach is needed since no one can foresee the market behaviour in advance.