As your business grows, you might start to see more revenue coming in from different countries, like a chef adding new flavors to a dish. But just like adding spices, managing multiple currencies can be tricky. A little too much fluctuation, and your profits could take a hit. This is where hedging comes in, acting like a recipe that balances the flavors to keep your business tasting just right. Here are some simple yet effective ways to use hedging to protect your business from currency fluctuations, making sure your financial dish stays balanced as you scale.
Let’s say you’re a restaurant that started serving a few international dishes. The ingredients you buy from overseas only makes up 20-30% of your total cost, so you don’t think too much about it. But if those ingredients suddenly cost a lot more because of a shift in exchange rates, your profits could shrink. The same goes for companies with a small percentage of their revenue in foreign currency. While it might not seem like a big deal now, as the business grows, the absolute value of these fluctuations could significantly impact the profit.
What is Hedging?
Imagine you’re shopping for groceries, and you notice that the price of your favorite coffee beans fluctuates wildly. One day they’re $5 a bag, and the next they’re $7. If you could lock in the $5 price for the next six months, you’d do it, right? That’s essentially what hedging does for businesses dealing with foreign currencies. It locks in exchange rates to protect against future price fluctuations, ensuring you know exactly what you’re paying some time in the future.
How to get started?
For SMEs just dipping their toes into the world of hedging, starting with something simple and cost-effective is the best approach. Here are some strategies to consider:
- Forward Contracts
A forward contract is like agreeing with your coffee supplier to buy a bag of beans at today’s price, even if you’re not going to need them for another three months. In business terms, a forward contract allows you to lock in an exchange rate today for a transaction that will happen in the future. This way, you protect yourself against any sudden spikes or drops in the currency’s value.
- Example: If you know you’ll need to pay a supplier in 10,000 USD 3 months from now, you can lock in today’s rate. So, even if the USD strengthens, you won’t have to pay more than you budgeted.
- When to Use: Forward contracts are ideal when you know exactly how much and when you’ll need a foreign currency. They’re straightforward and usually come with no upfront cost, making them a great starting point.
- Matching Revenues and Expenses
This is like balancing your diet. If you’re eating a lot of spicy food, you balance it with something cool like yogurt. In business, if you’re earning revenue in one currency (say USD) and have expenses in the same currency, you naturally hedge because any fluctuations won’t impact your profit margins as much.
- Example: If you earn 30% of your revenue in USD and also pay for some of your expenses, like raw materials, in USD, you’re already naturally hedged. Your revenue and expenses balance each other out.
- When to Use: This is the easiest form of hedging since it doesn’t require any special financial contracts. It works best for businesses with a balanced inflow and outflow of foreign currency.
- Options
Options are like buying an umbrella before you know if it’s going to rain. You pay a small amount for the option to buy or sell currency at a specific rate, but you’re not obligated to use it if the weather stays nice—or in this case, if the exchange rate is favorable.
- Example: You pay a small fee for the option to exchange SGD to USD at a certain rate in three months. If the USD strengthens, you can use the option and benefit from the lower rate you locked in. If the rates don’t change much, you can choose not to use it.
- When to Use: Options offer more flexibility than forward contracts because they give you the right, but not the obligation, to execute the transaction if market conditions are favorable. While they come with a premium cost, similar to insurance, they protect against extreme currency fluctuations. In contrast, forward contracts lock you into the transaction, regardless of future market rates.
- Passing on the Risk
This strategy is like adjusting the price of your restaurant’s menu items based on the cost of ingredients. If the price of coffee beans goes up, you raise the price of your coffee. Similarly, you can adjust your invoice prices based on currency fluctuations.
- Example: If you typically bill overseas customers in USD, consider billing them in SGD instead. This way, any fluctuations in the exchange rate between the billing date and payment date won’t affect you directly.
- When to Use: This works well if you have a good relationship with your customers and they understand why you’re adjusting prices. It’s a straightforward way to pass on some of the currency risk.
Choosing the Right Strategy for You
Different hedging tools suit different business needs. Begin by evaluating your foreign currency exposure and risk tolerance. Choose a straightforward, cost-effective strategy accordingly. Many of my entrepreneurs peers have advised that it’s better to have predictable financial outcomes than to gamble on favorable exchange rate movements.
Adjust Your Hedging Strategy as Your Business Grows
As your business grows, so will your need to manage currency risk. The strategies that work for you now may need to evolve. Think of it like upgrading your car. When you’re just starting out, a simple sedan might do the job. But as your family—or business—grows, you might need an SUV or an MPV with more features.
- Increase Forward Contracts: If you’re currently locking in a portion of your foreign currency needs, consider expanding the percentage as your exposure grows.
- Use More Complex Instruments: Options and other derivative instruments might become more relevant as your business becomes more sophisticated.
- Hire a Specialist: As your hedging needs become more complex, having a dedicated team member or consultant to manage this aspect of your business could be worthwhile.
Start by consulting your corporate bank. When I began hedging 7 years ago, I chose Western Union for their competitive rates. If your transaction amounts are small, don’t bother hedging - the difference is often minimal. Focus on growing your business instead. Every time I get sucked into finding the most economical options for small purchases, I often remind myself the quote my mentor shared with me:
Hedging can sound complicated and scary, something that is only for the financial industry but it really isn’t. Start with simple, straightforward strategies shared above to experience what it’s like to have a peace of mind. These methods are easy to understand, inexpensive, and can be easily scaled up as your business grows. Remember, hedging is like an insurance policy for your profits. You might not need it every day, but when you do, you’ll be glad it’s there.