WIKIFX REPORT: The 3 elements of a successful FX hedging program

There are a number of effective hedging strategies to reduce market risk, depending on the asset or portfolio of assets being hedged. Three popular ones are portfolio construction, options, and volatility indicators. Here we will discuss the three key elements of FX hedging programs: goals, pricing and exposure. In doing so, were going to borrow a page from geography and use the concept of the cliff to better understand the nature of hedging programs.

Goals, pricing, exposure

One of biggest decisions surrounding a new hedging program is when to start. Let's tart by asking a simple question: do you wish to protect your firm‘s operating profit margin and company cash flows from currency risk？ Or do you desire to diminish the variability of your performance as measured in accounting terms in your firm’s financial statements？ (The two are not necessarily incompatible with each other).

Suppose for now that you want, first and foremost, to protect your firms operating profit margins and cash flows from currency risk. Here, the pricing criteria of the firm play a decisive role. We also need to understand the concept of the cliff. The cliff describes a sharp move, between two campaign/budget periods, in the FX rate that is used in pricing.

Ensure to Maintain the cliff!

Assuming you wish to keep steady prices during an entire campaign/budget period, and you can fully reprice at the onset of a new campaign/budget period. In that case, you will be passing the pricing impact of the cliff onto your customers. Your principal objective will be to protect the budget rate for that particular campaign/budget period with the help of a static hedging program.

Nevertheless, assume the firm doesnt have that capacity, or it simply desires to keep its prices as steady as long as possible. In that case, its principal objective will be to smooth out the hedge rate, which can be done through a layered hedging program. This allows the firm to keep relatively steady prices during a set of campaign periods without unduly hurting budgeted profit margins.

Lastly, and staying with cash flow hedging programs, a firm that faces dynamic prices will quite naturally update its prices frequently. Here, the cliff doesn‘t play much of a role. In this case, the firm’s principal objective is to protect the dynamic pricing rate, transaction by transaction, with the help of a micro-hedging program for firm commitments.

Types of exposure

Having discussed goals and pricing, we can deduce the type of exposure that needs to be collected and processed in each case. In both static hedging and layered programs, the exposure to hedge is the firms forecasted FX-denominated revenues and expenses. Here in the first scenario, these forecasts cover individual campaign/budget periods, while in the second case, the exposure to currency risk is estimated as a rolling forecast for a set of campaign/budget periods linked together.

Finally, in micro-hedging programs for firm commitments, as the name indicates, the exposure to hedge is the firms sales/purchase orders, either on an individual or on an aggregated basis. Here, the critical difference is that these are contractually binding transactions and, as such, they are not forecasts at all.

To this extent, we have dealt only with cash flow hedging programs. Companies, however, may have as their objective to minimise the variability of performance as measured in accounting terms by financial statement results. Here, the adequate program is a balance sheet hedging program. The type of exposure that needs to be collected and processed are the invoices that correspond to sales/purchase orders.