To hedge or not to hedge?

The unpredictability of foreign exchange (FX) markets can complicate financial planning. Since FX forecasts are often unreliable, analysing the potential impacts of FX rate volatility in financial modelling is challenging.

Utilising Sensitivity and Scenario Analysis

Sensitivity and scenario analysis in financial planning can help businesses assess the potential impacts of FX movements on financial performance. These analyses aid in defining risk appetite, informing FX hedging strategies, and often serve as the starting point for FX hedging discussions.

Unpredictability is inherent in FX markets, making financial planning and analysis (FP&A) difficult for businesses operating across borders. Given the unreliability of FX rate forecasts, businesses need effective methods to evaluate a range of potential outcomes for financial models.

Benefits of Sensitivity and Scenario Analysis

Employing sensitivity and scenario analysis can significantly improve financial planning by:

- Revealing Faulty Assumptions: These analyses can identify questionable assumptions in financial models, highlighting deficiencies in decision-making frameworks.
- Highlighting Overlooked Variables: They increase clarity about the factors driving financial performance, ensuring all relevant variables are considered.

This approach is particularly valuable for assessing the implications of FX movements on financial performance and is a key component of FX hedging discussions for many of Monfor’s clients.

Multiple Approaches

There are several approaches to scenario and sensitivity analysis, each with its pros and cons. Monfor’s clients often use two main methods:

Historical Scenario Analysis
This method examines past market events to understand likely drivers of FX rate movements.
- Pros: Intuitively understood and easily explained to stakeholders without finance backgrounds. It does not assume that market movements are normally distributed and linear.
- Cons: Historical patterns may not hold true in the future; while history may rhyme, it rarely repeats exactly.

Parametric Delta-Normal Analysis
This method relies on statistical methods to estimate probabilities of various outcomes, similar to the Value-at-Risk (VaR) approach.
- Pros: Forward-looking results provide a sense of potential outcomes at given forecast probabilities.
- Cons: Quantitative methods are difficult to explain and assume a normal distribution of returns, which rarely applies to FX rates. Therefore, results should be interpreted cautiously.

Without conducting sensitivity analyses, businesses may learn the limitations of their models the hard way. Collaboration between FP&A teams, treasurers, and FX providers is crucial for global businesses to protect their profit margins effectively.

How to Build, Implement, and Monitor Your Strategy

Next, we address the how: building your strategy, implementing it, and then reviewing and monitoring it.

A well-defined strategy can significantly reduce the uncertainty around whether or not to engage in hedging. While no strategy is perfect, having one is far better than none. You can always refine and improve it over time.

Here are some important considerations to help you develop and implement your strategy:

Pricing
Pricing is not just an accounting item; it's a core component of your business. Consider how you price your products, the duration for which prices are fixed, and how frequently you can adjust your pricing.

Your Risk Profile
Everyone's risk profile is different. Determine your comfort level with taking on some of the currency risk. Are you willing to warehouse some of the risk yourself?

Your Budgeted Rate
Identify the rate you need to achieve on your FX transactions to protect your margins. Assess whether this rate is realistic and achievable.

Your Financial Position
If you are in a strong financial position, you might decide to hedge a portion of your requirements. Your financial stability can influence your hedging decisions.

Your Competition
In highly competitive sectors, currency hedging might be more challenging. Analyse how your competitors manage currency risk and how it impacts your strategy.

Execution
Ensure that you can execute the plan and strategy you have in place. Understand the products you are using and the potential outcomes. Be prepared to stay the course, even when tempted to change your strategy based on market views.

Every business is unique, with its own risk appetite. Your strategy should be tailored to your specific circumstances, not influenced by what competitors or vendors might do, or by the opinions of those unrelated to your business. Listen to your business; it will guide you in determining the best course of action.