In the modern world businesses are becoming more and more global. The world is becoming increasingly connected thanks to improved means of communication and transportation. Many companies hire employees working remotely from another part of the globe. While others are mostly getting major components and materials for creating goods and services from foreign countries. In short, the world is highly connected and currency value fluctuation in one country can easily impact businesses operations in another one.
Smart businesses do their best to limit their exposure to risks related to currency exchange. In this regard hedging is important since limiting FX risks allows companies to worry about currency rates less.
Foreign exchange markets or FX for short have various participants. Some are motivated by a desire to profit from currency fluctuations, while others are there to exchange currencies.
It should be noted that hedging is not for increasing profits. Its main purpose is to limit losses. In currency trading hedging means taking an opposite position to existing orders in order to limit risks. Hedging is very similar to insurance, it is costly, but on the other hand makes everything more predictable. Most businesses value a predictable and stable environment more than potential for high rewards that come with high risks.
Falling domestic exchange rates makes imports more expensive. And in case you are a local producer, falling rates on foreign currencies will make it more difficult to compete with lower prices for you.
FX market exposure is one of various ways that businesses can use to limit their risks. For instance, if a company is located in China and hires product research and design specialists in the USA, purchasing the US Dollar against Chinese Yuan in the Forex market would decrease the risks.
Each business has different needs and challenges, and therefore, the optimal risk exposure should be calculated individually.
It should be noted that FX exposure should not be static. Companies do their best to have dynamic exposure that corresponds to reality. There might be an increase in demand on foreign raw materials or increase in foreign workforce, and risk exposure should be changing accordingly. However, the FX market also comes with its challenges.
One way businesses can limit their risks is to contact their partners in foreign countries and make agreements to use the company’s local currency for transactions. However, this might work when selling products, but when it comes to purchasing materials, usually sellers dictate the conditions.
Businesses need to take into account a couple of factors before planning their FX exposure:
- Are they receiving income in foreign currency?
- Are payments to suppliers and employees made in foreign currency?
- When they take out business loans, are loans in local or foreign currency?
- Does the company hold offshore assets?
To sum everything up, businesses that are dependent on materials or workforce in foreign countries and their income is in one currency and expenditure in another, use hedging strategies to limit exchange rate risks. Hedging is not intended for increasing profits, the main idea behind it is to limit risks. Creating an optimal exposure in the FX market is very difficult as each company needs to take into account various factors: including their income currency, expenditure on materials and expenditure on salaries.