Foreign exchange - Protect yourself in a volatile world
By Chris Alp
Managing the risk of volatility in the world’s sixth most traded currency…the Aussie dollar
It takes many years of burnt fingers before business owners eventually fully protect themselves from the risk of losses from falling (importers) or rising (exporters) exchange rates.
All too often, greed overpowers caution. A positive trend seems unstoppable and protection is considered unnecessary. In July 2008, the media were talking up the probability that the $AUD would reach parity with the $USD. It didn’t quite make it. By late October 2008, the exchange rate fell to nearly 60 cents. The impact was catastrophic for importers without hedging. Disastrous for one client (neither an importer or exporter) who was buying a new machine for $USD 2.5 million, and who ended up paying over $4 million.
The same collapse was a long awaited relief to exporters suffering from a previously high Aussie dollar. For them, relief was short lived.
What we observe is that this keeps happening…both up and down, as it will forever. The forces that drive the exchange rate seem obvious…overseas borrowings, inflation, resource prices, interest rates and trade deficits. Add to that market sentiment, political factors and currency speculation and you can see why two reputable economists can hold totally contradictory views about the future. Our own internal experts disagree about the future rate for our currency.
The lesson is that we are participants only. Any attempt to outguess the market comes with a big risk.
So, what are the two best techniques to help you manage your currency risk?
Option 1: Foreign Exchange Contract
FX Contracts are well understood by most business owners.
It is an agreement to buy or sell Australian dollars for a given amount of a foreign currency at a specified future date in exchange for a margin.
For example, an importer seeks to protect a $USD payment due in December.
0.8198 Current spot rate AUSD/USD
(0.0070) Four month forward margin
0.8128 Forward exchange rate
The key issues with an FX Contract are:
- It is simple to understand and your bank’s exchange rate department can advise you how it works and what risks you are undertaking.
- Contracts can be delayed or brought forward if delivery dates change.
- Margins for goods or equipment bought or sold are locked in today for a small premium.
- Regular imports/exports can be protected using a regular program of buying currency.
- The risk of an adverse movement is removed but the loss of opportunity from a favourable movement is also lost.
Click here to check out ANZ Bank’s full description of the mechanism. All banks provide this product.
Option 2: Foreign Exchange Option
For those who want to have their cake and eat it too!
A foreign exchange option gives you the right (but not the obligation) to buy or sell a given amount of foreign currency at a specified future date in exchange for a premium. The premium is primarily dependent on the term of the option, the rate you wish to protect (strike rate) and the market’s view of the future.
For example, our importer seeks to protect a $USD payment in December, but still wants to benefit should the rate rise.
0.8198 Current exchange rate AUSD/USD
0.8304 Forward exchange rate
0.8000 Strike rate
(0.0105) Strike price (premium)
So, for a premium of 1.05 cents in this simplistic example, our importer will choose to exercise the option should the rate fall below 0.80, otherwise, will allow the option to lapse and convert to USD at the prevailing rate.
- The key issues with an FX Option are:
- Relatively simple to understand.
- The lower the strike rate, the lower the premium.
- If currency moves substantially, the new rate could again be locked in.
- Premiums are the price of upside.
For more info, click here to check ANZ Bank’s FX Option product. All banks provide this product.
When evaluating what type and level of protection is appropriate, always consider the impact of both a favourable and unfavourable movement. If an unfavourable movement is catastrophic, you need protection. If missing out on a favourable movement is commercially disadvantageous, consider an FX Option.