Why companies hedge their foreign exchange exposure

Paul Martin Nerby

Paul Martin Nerby

Senior FX Specialist

Unless your company is only dealing with national customers and suppliers, your company is bound to be exposed to FX risk. If you are an importer buying your goods abroad or an exporter selling internationally, or if you are invested elsewhere than domestically, you are vulnerable to FX risk.

Movements in FX rates can be detrimental to your profits and it can certainly prove to be a considerable risk to your book valuations. If you are running a high volume low margin business, small fluctuations in the exchange rate can make a big dent in your profits.

A currency will typically appreciate whenever a country is doing well, based on a number of economic indicators, such as GDP growth, unemployment rate, inflation rate, budget balance, current account balance and the value of PPP amongst others. In a benign investor climate money will easily flow into a country doing well, resulting in demand for that country’s currency which again leads to appreciation. CHF and JPY are typically considered to be strong currencies in that regard. The US is also known historically for running a strong dollar policy.

On the flip side, the opposite holds true for the depreciation of a country’s currency. If the country has slack monetary and fiscal control, the investment opportunities will be less attractive and hence the country’s currency will be less in demand, leaving room for depreciation. In addition you need to take into account potential shocks such as currency intervention from the central bank.

Add to that an earthquake, terrorist attacks, or other negative, external shocks which can have large and sudden impacts on the exchange rate and it is easy to see the basis of why you should hedge your FX risk.

In the short term picture, daily fluctuations find their rationale in short term demand and supply from commercial transactions as well as a number of market participants not necessarily with the underlying need for currency (speculators), and all the psychology that comes with it. On a day to day basis, the currencies fluctuate up and down in a seemingly random fashion. The endless parameters that in sum makes up the demand and supply of the FX market is impossible to know, fully let alone monitor.

How can you, as a single merchant in this market, know better than the aggregated market knowledge, where the next market movement comes? The only true answer is that you can’t. And this is why most companies with FX risk exposure hedge their future cash flows, as opposed to taking a speculative approach on future market movements.

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