SMEs: 9 tips for improving your hedging against currency risk

An inherent feature of any international foreign exchange transaction, currency risk weighs on your company’s trading margins.

Owing to its geographical proximity to the European Union (EU) and the worldwide reputation of some of its production sectors (luxury goods, pharmaceuticals and electronics), Switzerland is home to many SMEs whose turnover largely comes from exports.

As a result, currency risk regularly erodes the margins on these international sales. Fortunately, there are solutions for adapting your sales process in order to reduce this loss and preserve your profits!

#1 Understanding the different types of foreign exchange risk

Although frequently used in international trade, the term “currency risk” is often subject to loose or inaccurate use.

Indeed, any commercial purchase or sale between two parties from different countries exposes those involved to various foreign exchange risks, namely:

• Transfer risk: this refers to the risk that the government of one of the parties might implement a policy preventing any international currency transfers;

• Convertibility risk: this refers to the risk that the government of one of the parties will refuse to sell any currency in the form of loans or bonds;

• Transaction risk: this is the risk that the currency will appreciate or depreciate between the date of invoicing and the date of payment;

• Economic risk: this refers to the risk that the foreign exchange market may affect a product’s structural profitability by reducing the value of its revenue and/or increasing its costs.

This article focuses on these last two types of risk (transaction risk and economic risk), in order to minimise as far as possible the losses caused by a potential appreciation or depreciation of currencies.

#2 Understanding the source of foreign exchange risk

Because the sales process involves numerous stages (quote, invoice, payment…) and the value relationship between two currencies in an international transaction changes over time, the prices quoted at invoicing are subject to often unpredictable variations.

It is therefore to protect against this instability between the Swiss franc and any other currency that a Swiss seller may find it worthwhile to adopt a solution suited to their foreign exchange needs.

NB: Although trading margins become uncertain due to fluctuations in exchange rates, hedging against currency risk comes with variable costs. Before anything else, it is therefore essential to ask the following question: Is it worthwhile to put in place a hedge against currency risk?

#3 Contact the right person depending on your foreign exchange needs

Depending on the complexity of the foreign exchange transactions you wish to carry out, the amount and frequency of your transactions, and the type of solution envisaged, the ideal point of contact will not be the same.

Banks are the traditional intermediaries for any currency hedging transaction. Because currency risk is a familiar subject for properly trained bankers, banking offers generally inspire confidence.

Nevertheless, this solution involves several management constraints, in particular:

• opaque pricing;
• often high costs (management fees, premiums);
• reduced accessibility;
• delays that are sometimes too long;
• exchange rates that are sometimes out of touch with market realities.

Currency brokers therefore represent an attractive alternative, particularly in terms of ease of management, since the advent of the internet has enabled their online development, often at much more reasonable rates given their lighter cost structure – as is the case with the online currency exchange service b-sharpe.

#4 Start trade negotiations with your counterpart

While, as a general rule, payment made by the buyer is expressed in their national currency, it is entirely conceivable for the seller to require payment in their own currency.

However, such an approach transfers the entire currency risk to the buyer. To afford this kind of negotiation, it is therefore better to have a solid sales case, for example:

• to hold a monopoly position in the market;
• have unique and irreplicable competitive advantages;
• offer extremely low prices that offset any currency risk for the buyer;
• maintain a strong relationship of trust with the buyer (long-term customer loyalty policy).

Beyond the radical nature of such a stance, negotiation is a fundamental process for distributing and balancing currency risk as effectively as possible between the two parties.

Please note : Whatever decision is taken, negotiating how currency risk is shared between two companies is a sensitive matter, since over the long term it will necessarily produce a winner and a loser depending on how exchange rates move.

#5 Agree on indexation clauses in advance to hedge against currency risk

With a view to agreeing on the measures to take in the event of a change in the exchange rate for the currency pair between buyer and seller, the parties can agree on various clauses, more or less advantageous to one or the other:

• The price adjustment clause: this involves passing on the full cost of exchange rate fluctuations to the buyer, in line with the advice given earlier. This option clearly favours the seller;

• The multi-currency clause (multiple currency clause): this involves stating the invoice amount in several currencies. The party designated in the contract selects the currency of their choice upon maturity. This option benefits the party designated as the decision-maker;

• The tunnel indexation clause: this involves fixing prices prior to payment, provided that exchange rate fluctuations remain within a ‘tunnel’, i.e. between a minimum threshold and a maximum ceiling. Beyond these limits, exchange rate risk will affect pricing;

• The currency indexation clause: this involves setting the price in relation to a third-party benchmark (such as a less volatile currency) in order to enhance exchange rate stability;

• The currency basket indexation clause: this involves the same process, but with values pegged not to a single currency but to a basket of currencies such as the SDR (here too, this reduces volatility as well as currency risk);

• The currency option clause: this involves setting the price in relation to a third-party benchmark; however, in this case, the choice is made by one of the parties prior to each transaction;

• The risk-sharing clause: this involves both parties agreeing in advance to a specific percentage allocation of the foreign exchange risk (for example, 50% for each party).

#6 Opt for a third-party currency and play the neutrality card

Several reasons may lead the parties to choose a third currency as an intermediary between the two national currencies. These can stem from a commercial agreement between buyer and seller, or from constraints imposed by government.

Indeed, some legislation requires the use of the national currency for any transaction carried out there. Similarly, certain geographical areas can prove favourable to trade, for example in the context of import-export across several regions. Sometimes, certain states have no foreign exchange market at all: it then becomes necessary to go through a third country.

Please note : Such a decision brings into play the concept of cross currency risk, which, while sometimes convenient for everyone, makes the currency hedging process more complex.

#7 Enter into a cross-currency swap to maintain a balance of payments

Literally translated, a currency swap consists of an initial exchange of foreign currencies (the amount of which is mutually agreed) between the two parties, each of which commits to paying the other interest at a predetermined frequency. At maturity, the two companies finally commit to returning the stipulated amount to each other.

Good to know : A currency swap can be described as a parallel loan between the two companies.

Exporters, for their part, can apply for an export swap; that is, an advance in convertible currency granted by the central bank. This advance is repaid by the exporter once their payments are received.

#8 Setting up a subsidiary abroad to tap into the most profitable markets

Depending on the case, a high volume of production or turnover can justify, for certain companies, undertaking the setting-up of a subsidiary in the target country. Although this approach is heavy and costly, it can allow the company to transfer currency risk to its subsidiary rather than to the parent company.

When the flow of goods exported to a foreign country becomes large enough, it can be cost-effective to shift some of your costs and revenue to a subsidiary on the ground. Such a legal manoeuvre is, for example, entirely conceivable between Switzerland and the EU.

However, a few points need to be understood in advance, namely:

• your company’s profitability and growth objectives;
• the culture and professional practices of the target market;
• the legal form of the entity to be established locally;
• the network of potential partners to contact locally;
• the members of your team who are likely to work abroad.

#9 Manage your cash flows to minimise the amount exposed to foreign exchange risk

By internationalising your production and your sales approach, it is possible to pursue a netting policy. This consists of balancing the amount of receipts and disbursements of your overseas subsidiary in order to reduce the balance exposed to currency risk.

In practice, the parent company’s debts can be transferred to your subsidiary during periods when the foreign currency appreciates against the CHF, in order to offset the turnover generated abroad (thereby reducing the associated currency risk) while relieving your company of its liabilities.

The whole challenge, then, is to make the most of favourable movements in exchange rates in your currency pairs, in order to optimise the value of your foreign exchange transactions. This technique of timing foreign exchange operations is known as leads and lags (termaillage).

Please note : Such a practice is both complex and time-consuming; the benefits of leads and lags must therefore always be weighed against the cash flow constraints they create.

Consolidating orders and payments makes it possible to better control inflows and outflows, while reducing the number of transactions to manage. Your company (as well as the banks) will thereby optimise both its hedging against currency risk and its cash management.

You now know 9 ways to manage your production and sales processes in order to reduce the currency risk attached to your company’s international foreign exchange operations!

Do bear in mind, however, that other, more technical methods exist for optimising your currency risk hedging, which will require greater involvement and expertise in the foreign exchange markets.