How to effectively deal with over-hedging

Managing currency risk is essential for any business dealing with international transactions. One of the most significant issues in currency management is over-hedging, which can cause financial losses for the company.In this blog post, we will explore what is over-hedging, how it impacts finance teams doing currency management, and how currency managers can solve this problem using automation solutions.To illustrate the best way to solve this problem, we will use a case study of a medium-sized German exporter that sells in US dollars and other emerging market currencies. Find out more about this in our CurrencyCast episode.Through this, we will be able to explain how treasurers can effectively deal with the problem of over-hedging to protect the firm's budget rate.Let's jump into it.

What is over-hedging?

Over-hedging is a risk management strategy that describes the situation of a firm that has hedged in anticipation of exposure to FX risk that has failed to materialise completely.Over-hedging is common in companies with low forecast accuracy that apply static hedging, with a big hedge taken at the start of the period.Firms that find themselves in a situation of over-hedging should unwind some of their hedges in order to reduce this risk and increase the firm’s borrowing capacity.

Why is over-hedging a problem?

This leaves the company vulnerable to potential over-hedging, which can lead to potential losses. Over-hedging can also lead to higher hedging costs, which can impact the company's profitability.Over-hedging is a serious financial problem. However, it is key to remember that all companies operating internationally are exposed to some degree of currency risk. The key is to manage this risk effectively.In general, over-hedging is more of a risk in markets with high volatility. That's why it is very important for companies to implement the right hedging programme to avoid interest rate risk.But, how can currency managers do this?

A real case: a medium-sized German exporter

To illustrate how treasurers can effectively deal with the problem of over-hedging, we will use a real case of a medium-sized German exporter that sells stand-alone machinery equipment in Asia and other emerging markets.Their prices are mostly set in U.S. dollars, but also in other foreign currencies, for the duration of the entire campaign period and then reset at the onset of a new budget period.The budget rate is set with a consensus of investment bank forecasts, to which a markup of between 2% and 4% is added, depending on the volatility of the currency involved.The Treasury team then decides to hedge 80% of the budget at the start of the period for Q1 and Q2, and repeats that operation in May, for Q3 and Q4.

What are the main challenges of over-hedging?

However, this company faces four major challenges:

1. The risk of over-hedging: large hedges at the start of the period leave the company vulnerable to potential over-hedging, even as a significant chunk of the exposure is left unprotected.
2. The high cost of hedging: hedging is expensive due to unfavourable forward points when selling in US dollars.
3. Poor visibility: poorly collected exposure data at the company's subsidiaries undermines overall visibility.
4. Manual processes: tasks are manually executed in a time-consuming and resource-intensive way.

Despite all of this, there are ways the German firm can overcome these hurdles.

How to solve the problem of over-hedging

The German exporter can implement an automated FX hedging programme to face the challenges. But before that, they need to gather some key information on the FX exposure and upload it to the software. And, this data must fulfil several criteria in terms of timing, detail, connectivity, and control.In terms of timing, there are two important moments: the moment the budget is created and when each sales order is confirmed. In terms of detail, information about sales orders must include the amount of the sale, the currency to be sold (in this case mostly US dollars), the currency to be bought (in this case euros), and a reference number for traceability purposes.Then, in terms of connectivity, API-based connectivity ensures that the data will flow seamlessly from the company's ERP. Finally, in terms of control, proper automated validation rules must be set to ensure control over the exposure data.Having this information ready will ensure that the automation solution will procure the best hedging strategy that fits the company's needs.In this case, the automated FX hedging programme best suited to tackle the challenges faced by the company is a combination of a static hedging programme with conditional orders for the forecasted exposure, coupled with a programme to hedge incoming firm sales orders.Now let's see how this benefits the company when doing currency hedging.

Benefits of automation

As large initial hedges are downsized, the company can secure the budget rate. And by setting conditional FX orders on the remaining forecasted exposure, the solution will make sure that the average budget rate exactly matches the firm's budget rate. Even in a worst-case scenario in currency markets.By downsizing a large initial hedge, we’re also by definition reducing over-hedging risk and the cost of hedging in the face of unfavourable forward points.And finally, by selling firm sales orders the hedging strategy automatically adjusts the remaining exposure to currency risk, which further reduces the risk of over-hedging.

Measuring the success of not over-hedging

To better understand these benefits, we have to look at the numbers. With historical FX rates from 2017 to 2020, the combination of hedging programs would have outperformed the company's budget rate in three out of the four years.In 2019 alone, the company would have outperformed an average of 5.8% and the distance between the average hedge rate and the company's budget rate.So, here is the key takeaway. As long as Stop-Loss orders remain untouched and hedges are executed on the back of firm sales orders, the company locks in an average hedge rate that is more favourable than a budget rate.The higher the proportion of hedges that are executed on the back of firm sales orders, the higher the degree of overperformance, and the lower the residual forecasting risk.In 2017, about 66% of the hedges would have been executed on the back of firm sales orders. The remaining 34% would have been based on forecasts. In 2019, that proportion would have reached a full 100%.But when things went wrong in foreign currency markets, like in 2018, stop losses would have been triggered and the hedge rate would have equalled the company's budget rate.And with a positive turn in foreign currency markets, like in 2019, the firm would have generated an extra €460,000 on the back of a €20 million exposure. Those are outstanding results indeed!As you have seen, companies that want to overcome the ever-present currency management problem of over-hedging need to find an automated FX risk management solution. This will protect the firm's budget rate and boost profitability, even in scenarios of high volatility.If you want to know more about how our currency risk management solution can help companies like yours avoid the over-hedging problem, check out our case study.