To hedge or not? Protecting bottom lines in volatile times

In today's economic landscape, UK businesses are grappling with a significant dilemma—how best to manage the financial risks associated with currency volatility.

With higher borrowing costs squeezing margins, businesses must weigh the advantages of hedging against the operational and financial challenges it presents.

A well-thought-out hedging strategy is like traction control on a slippery surface, helping to maintain control and direction as market conditions shift. Without it, businesses risk spinning out of control when volatility hits.

This blog explores these challenges and offers insights into how corporates can effectively safeguard their bottom lines:

• Understanding the current hedging landscape
• Benefits of hedging in a volatile market
• High costs and credit constraints
• Navigating the future of hedging
• Outsourcing FX Functions

 

Understanding the current hedging landscape

Our revealed that hedging remains prevalent among UK corporates, with 76% of firms hedging their forecastable currency risk.

Interestingly, large businesses with over 500 employees are the least likely to hedge (68%), possibly due to their larger reserve capital, which cushions them from currency fluctuations. Conversely, smaller firms, which often lack such buffers, are more inclined to hedge.

In today's volatile economic climate, corporates are increasingly seeking stability, the mean hedge length has increased to 5.55 months, up from 3.78 months last year, indicating a growing desire among firms to secure longer-term certainty. Whilst the average hedge ratio remained stable at 45%.

 

Benefits of hedging in a volatile market

FX hedging is an effective risk management strategy for businesses exposed to foreign currency, helping to safeguard financial positions against adverse exchange rate fluctuations. Given current market conditions, 68% of UK corporates that don’t current hedge, are now considering this strategy.

Enhancing financial stability through forecasting

Hedging offers businesses the flexibility to plan ahead and safeguard their balance sheets against anticipated currency fluctuations. By improving forecasting accuracy, it provides greater predictability in financial planning.

It is therefore understandable that 53% of UK corporates are now planning to extend their hedge duration due to rising political tensions. By locking in exchange rates for future transactions, firms can improve budgeting with accurate cash flow estimates, enabling informed strategic decisions and leading to more stable financial results.

Variety of hedging instruments

With the various hedging instruments available, corporates have the flexibility to choose how to manage their currency risks.

Forward contracts, for instance, allow corporates to exchange two different currencies at a predetermined rate on a specific future date, with the rate being set at the start of the contract, providing certainty in costs and revenues despite market fluctuations.

On the other hand, option contracts offer more flexibility, giving businesses the right, but not the obligation, to exchange currency at a predetermined rate, which can be beneficial if market conditions change favourably, although they often come with pricey premiums.

Each hedging instrument has distinct features and requirements, allowing businesses to tailor their FX risk management strategies to suit specific needs and market conditions.

 

High costs and credit constraints

Increased cost of hedging

70% of UK corporates have reported an increase in the cost of FX hedging over the past year. Of those firms that don’t hedge their currency risk, 76% cited high costs as the primary deterrent.

This issue is particularly pronounced among smaller companies with 50-99 employees, with 85% experiencing rising hedging costs compared to 59% of larger firms with over 500 employees. This may be due to smaller companies having less negotiating power and fewer resources to manage financial risks effectively.

The increasing costs of hedging are not just affecting decision-makers; they directly influence corporate priorities. For 31% of UK corporates, reducing costs is a top priority, while 29% emphasise the need for cost transparency. These figures underscore the weight of FX costs on corporate strategies and how they can even discourage proactive risk management.

Stricter credit market

Concurrently, UK businesses are facing a tightening credit market. An overwhelming 74% of corporates report that credit providers have made it harder to access hedging in the last year. This trend has been most acute for accountants and CFOs, with 85% experiencing stricter lending criteria. Smaller companies are again at a disadvantage, with 87% reporting tougher credit conditions, compared to 59% of larger firms.

Additionally, 79% of corporates have noticed a rise in interest rates and fees, a sentiment echoed by 88% of accountants and CFOs. This financial environment adds another layer of complexity for businesses contemplating hedging as a strategy to mitigate currency risk.

 

Navigating the future of hedging

Corporates turn to options

Diversifying hedging instruments is crucial to reducing FX risk, by spreading exposure across different assets, corporates can minimise the impact of market volatility, and enhance the potential for more stable returns.

FX options are a financial derivative that grants the holder the right, but not the obligation, to exchange a specified amount of one currency for another at a predetermined exchange rate (strike price) on or before a specified date (expiration date).

Options can provide the reassurance of hedging with capped downside risk, it is therefore unsurprising that 64% of corporates have started utilising FX options more frequently.

Leveraging FX technology

Many corporates still cling to outdated, manual processes like phone calls (34%) and emails (32%) to instruct FX trades.

Leveraging technology can help businesses automate their entire FX workflow, from execution to reporting, freeing up resources to focus on core business activities and enhancing team efficiency. For UK corporates, automating manual processes is a priority in FX management, as 41% emphasise its significance.

Engaging with various credit providers

Relying on one or two counterparties for liquidity is like putting all your eggs in one basket. As seen in the 2023 banking crisis, the loss of a key counterparty can leave businesses stranded, unable to trade. Businesses should explore technology-driven alternatives that diversify their liquidity providers, ensuring they’re never vulnerable to a single point of failure.

Additionally, working with various counterparties allows you to leverage competitive pricing, helping to drive down costs and ensuring you best execution.

 

Outsourcing FX Functions

Outsourcing FX functions can be a strategic move for corporates looking to focus on their core operations while managing currency-related risks efficiently. By partnering with specialised FX service providers, businesses can access expert insights, advanced technology, and comprehensive market analyses without the need to maintain an extensive in-house FX team.

Setting up and onboarding new FX counterparties, centralising price discovery and navigating the post-execution phase often have their own complications and can be a huge administrative burden for some corporates, eating up much-needed time and resources. In fact, 34% of UK respondents said they use outsourcing as it provides greater scalability and flexibility in operations.

Following episodes like the forex rate-rigging scandal in 2014, many market principles and regulations were introduced, such as the FX Global Code of Conduct and MiFID II, to avoid crises like this again. Whilst overall beneficial to the ecosystem, these rules and regulations require a lot of work in order to be met. This is why 29% of respondents say that they use outsourcing for risk management and compliance purposes.

 

Conclusion

In a world of economic uncertainty, hedging remains a powerful tool for protecting your bottom line. However, rising costs and credit constraints present significant challenges that require strategic navigation. By adopting a comprehensive approach that balances risk management with financial agility, UK corporates can position themselves to thrive amidst volatility.

If your organisation is grappling with these decisions, you can contact us here to discuss how can provide a tailored FX workflow solution to meet the needs of your business. In these times, the right guidance can make all the difference.

 

 

This blog post examines & refers to the data and results of a survey conducted by Censuswide on MillTechFX’s behalf conducted between 17 June and 30 September 2024 of 250 CFO’s, treasurers and senior finance decision-makers in mid-sized corporates (described as those who have a market cap of $50mil up to $1 billion/£38m to £770m), in the .

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