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3 Common Misconceptions When Hedging the Budget (and How to Avoid Them)
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Discover essential FX hedging strategies and currency management best practices from our foreign exchange experts.

3 Common Misconceptions When Hedging the Budget (and How to Avoid Them)

04/07/2024
·
5 min.
Agustin Mackinlay
INDEX

In our previous blog, we discussed the type of pricing parameters that should guide a company’s choice of FX hedging program. We saw that protecting the budget rate, one period at a time should be prioritised by firms that use a ‘catalogue-based’ pricing model.

This second blog delves into the most common mistakes treasury teams make as they attempt to hedge company budgets. These misconceptions include:

  1. Confusing campaign and budget. Campaign periods may overlap budget periods, and that confusion must be avoided by FX risk managers.
  2. Setting an inadequate budget rate. The choice of the budget rate may fall short in terms of attainability and stability —we show how this can be improved.
  3. Hedging right away. This classical approach puts companies at the mercy of forecast accuracy. It may also yield a subpar financial performance.  

Campaign or budget? A classical misconception

The confusion between the campaign and budget period is a frequent one. Consider the example of a company that sets its 2024 and 2025 budgets by projecting a forecasted income statement, as shown in the illustration below.

Campaign and budget periods may or may not overlap. There is no reason why a yearly budget should precisely match the forecasted revenues and expenditures of an individual campaign. In fact, the two are unlikely to overlap each other, as is common in fashion firms that display different collections during the same year.

The questions for the treasury team are: What is the exposure that needs to be hedged? And when is the corresponding settlement to be expected? In our example, hedging the expected AR from the start to the end of the year would reflect a double confusion:

  • Confusion about the exposure. Only €200 million would be hedged instead of €300 million of the campaign. What needs to be ‘protected’ is the budget FX rate of the campaign, rather than the FX rate for the annual budget.
  • Confusion about value dates. In our example, settlement is expected both in 2024 and 2025. This is the ‘cash flow moment’ that informs the treasury team about the hedging horizon, i.e. the value-dates of the corresponding derivatives instruments.

The correct solution is to hedge the forecasted exposure for a campaign until the expected settlement date of the corresponding commercial transactions. This policy allows the company to effectively protect the firm’s economic exposure to FX risk—but all of this needs to be effectively communicated to the C-suite to avoid confusion. 

Let’s talk about the budget rate

There are several possibilities to create an FX budget rate, the exchange rate that is used in pricing during an individual campaign or budget period. The following table, taken from Bloomberg, provides some examples of common practices regarding the choice of the budget rate:

Source: Bloomberg

As we can see from the table, relevant questions about the budget rate include: (a) is it attainable? (b) is it achievable? (c) is it stable? Let us take an example. If the treasury team uses the spot rate that prevails at the time the budget is being created, the question of whether it is attainable relies largely on the cost of carry.

The cost of carry, in turn, is determined by the interest rate difference between currencies. Needless to say, this issue has gained in importance since 2021, when central banks began raising interest rates —each at its own pace— to fight inflation and inflation expectations.

FX markups: the case for an off-market exchange rate

Setting an off-market FX rate is a widely accepted practice when calculating the FX rate that is going to be embedded in pricing.

An example allows us to see how it may be constructed. A Europe-based company with EUR as its functional currency buys furniture in Asia, paying in USD. The firm sells in Europe during a campaign period, at a fixed ‘calendar price’ in EUR.

To arrive at the FX budget rate that is embedded in pricing, the treasury team takes —as a reference— the spot EUR-USD rate at the time the budget is created. It then ‘deflects’ that rate by, say, 3%. This less favourable rate constitutes a markup.

As such, it yields a higher profit margin than the prevailing spot rate. In the next blog we will see how treasurers can use conditional stop-loss orders to effectively ‘protect’ that FX rate during the entire budget period.

For now, let us note the tradeoff faced by the treasury team: the higher the markup, the more stable and achievable the budget rate—but the greater the detriment in terms of the firm’s competitive position.

This is why, in the event of favourable forward points —for example, when buying in a currency that trades at a forward discount, or when selling in forward premium currency—, such markups could prove unnecessarily costly.

An off-market FX rate: Budget rate with markup. (Example of a Europe-based firm with USD contracting costs)

  • Spot EUR-USD at budget creation: 1.0730
  • FX markup: 3%
  • EUR-USD budget rate: 1.0730 * 0.97 = 1.0408

Hedging right away? Don’t be so sure

When discussing how to hedge the budget, most textbooks —and many advisors— lazily limit themselves to a disarmingly simple, ready-to-use one-size-fits-all solution: just take a hedge right at the onset of the budget period. And do it for the entire amount of the budgeted exposure.

As readers of this blog know, such an approach does not take sufficient account of the variety of real-life situations. Immediately hedging the full forecasted exposure should only be considered in the event of: (a) close to perfect forecast accuracy; (b) favourable forward points.

When facing unfavourable forward points, or when less-than-stellar forecast accuracy is the norm, this may not be the best way for the finance team ro reach its objectives. Hedging right away exposes the firm to the dangers of under- or over-hedging—and to suboptimal financial performance. 

FX automation solutions allow finance teams to tackle these threats by taking advantage of what we call the benefits of delay. Delaying hedge execution yields quantifiable benefits in terms of financial optimisation and collateral management.

Importantly, it allows treasury teams to leverage the information coming from different company systems, and thus to reduce lingering concerns about forecast accuracy. This is the topic of our next blog.

Agustin Mackinlay
Agustin Mackinlay is a Financial Writer at Kantox. He has previously worked at an investment bank specialising in Emerging Markets. Agustin teaches several courses in Finance at LaSalle University and EAE Business School in Barcelona. He holds degrees from the University of Amsterdam and from the Kiel Institute of World Economics in Germany.
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