Businesses: which exchange rates should you use for your 2022 budget?
When finalising the budget for the coming financial year, it can be difficult to know which exchange rate to apply to cash inflows or outflows denominated in foreign currencies… It is therefore very tempting to rely on one’s gut feeling or on the forecast of one analyst or another, however well-known they may be.
However, the best approach is undoubtedly to proceed methodically and sensibly. So let’s put the crystal ball aside and explore together the best practices to adopt for a professional and reliable 2022 budget!
Do not try to predict the future
In order to forecast exchange rate movements, financial market professionals can use three main approaches:
- Purchasing power parity. This method is based on the principle that the same good or service should have the same value, regardless of the currency area. It therefore involves defining a benchmark basket of goods to calculate the ratio of their monetary values in one currency relative to another, in order to arrive at the theoretical exchange rate. However, local specificities (demographics, regulatory constraints, taxation, etc.) make this task relatively complex.
- Growth and interest rate differentials. This method involves comparing the real (inflation-adjusted) growth rates of different currency areas, based on the assumption that the more prosperous economic area will attract more investors and therefore see its currency strengthen.
- Econometric models. This method uses complex statistical models to attempt to capture exchange rate movements through an equation comprising multiple variables and factors.
Nevertheless, despite the existence of numerous models of varying degrees of sophistication, even professional analysts fail to achieve convincing results in their forecasting exercises, and as disappointing as it may seem, chance remains a better forecaster than strategists…
Since your role is not to speculate on the foreign exchange market, but rather to focus on the financial health of your business, it is therefore advisable to use the foreign exchange futures market and its forward rate to establish your assumptions.
Define your ‘budget prices’ and ‘reference prices’
For each foreign currency included in your forecast budget, you can therefore use the forward rate for that currency to draw up your projections.
This initial exchange rate will then serve as your budget rate – that is, the exchange rate at which you expect to carry out your currency conversions over the coming year. Importantly, your budget rate can be set annually or at a more frequent interval (quarterly or monthly) to update your assumptions as events unfold.
Once the budget rate has been defined, you must then set your reference rate, i.e. the exchange rate beyond which you must not go in order to preserve your company’s margins and profitability. It is therefore, in a sense, a ‘degraded budget rate’.
All other things being equal, the less sensitive your business is to exchange rate risk, the further your reference rate can be from the budget rate. In this regard, everything will therefore depend on your company’s foreign exchange policy and your risk aversion.
Running simulations based on different market scenarios and operational assumptions will enable you to anticipate and implement corrective measures if necessary.
Good to know: Make sure your company consistently uses the same budget rates and reference rates across all documents and departments!
Lock in your exchange rates with hedging
To avoid exceeding the reference rate set in your budget, you can implement so-called hedging strategies to lock in the exchange rate for your transactions in advance.
This hedging operation can then be set up to cover your entire financial year (macro hedging) or on an ad hoc basis to cover your transactions (dynamic hedging).
In the case of a macro hedging strategy, you must ensure that the size of your hedging operation is not too large in relation to your actual needs (risk of over-hedging), otherwise the hedge would increase your exposure to risk rather than neutralising it.
To do this, you could, for example, opt for partial macro-hedging so that you only hedge transactions that have already been invoiced or contracted in advance, and hedge the remainder as and when they arise.
And in the case of a dynamic hedging strategy, you will need to ensure (through a reporting system, for example) that the weighted average exchange rate of your transactions does not come too close to your reference rate.
Good to know: Make sure you always hedge your net exposure rather than the total of your positions; some long and short positions may offset each other automatically as part of a natural hedge.
Don’t forget the currency exchange and hedging fees!
As it involves a number of costs (both financial and in terms of manpower), the implementation of hedging strategies should not be a routine matter for your business, but should instead be the subject of a thorough analysis.
Finally, don’t forget to factor in the foreign exchange fees you’ll have to pay for your transactions; if you don’t have a specialist provider or if your transactions involve exotic currencies, these costs can quickly mount up!
You now have all the information you need to refine your budget forecast. For 2022, discover our currency exchange service for businesses and make real savings with complete transparency!
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