Discover essential FX hedging strategies and currency management best practices from our foreign exchange experts.
4 Reasons Why Budget Hedging Helps Protect Profitability
We are starting a series on the budget hedging topic to help you prepare for budgeting season and understand the importance of FX in the budgeting process. First you will need to understand the value of budget hedging for your business.
Budgets set out short-term plans to help managers run the business. They provide the means to assess whether actual performance was as planned and, if not, the reasons for this. They are an integral part of a planning framework adopted by well-run businesses.
How do budgets help managers run the business? Four key reasons are commonly cited:
- Budgets promote forward thinking
- Budgets help to coordinate the various sections of the business
- Budgets can motivate managers to better performance
- Budgets provide a system of control
Businesses of all sizes undertake budgeting and forecasting. The intricacies involved in the process are illustrated by the profusion of terms like periodic budget, rolling budget, master budget, zero-based budgeting, cash budget, revenue budget and many more. But what is the importance of foreign exchange in the budgeting process?
What pricing characteristics you have to consider in budget hedging?
Beyond the complexity that underlies budgeting in the business world, the single most important element from the FX point of view is the pricing characteristics/parameters of the business.
The key distinction to bear in mind is whether a business:
- Updates prices frequently
- Keeps prices steady during individual campaigns
- Keeps prices steady across several periods linked together
Frequently updated prices
When prices are frequently updated, FX hedging is conducted on the back of firm sales/purchase orders. In the lifetime of a typical commercial transaction, these orders reflect a contractual exposure to currency risk, as opposed to the forecasted or budgeted exposure. For this reason, we will not discuss this setup in this blog series.
Steady prices across budget periods.
When prices are kept as steady across several periods linked together, the exposure is in the shape of a rolling forecast of cash flows encompassing several periods linked together. The corresponding FX hedging programs —known as layered hedging— will be analysed in detail in another series of blogs.
Steady prices in individual campaign/budget periods.
Finally, many firms keep prices steady during a particular campaign or budget period and, as the following campaign or budget period unfolds, they simply reset their prices. This business model is sometimes referred to as ‘catalogue-based pricing’.
When risk managers refer to budget hedging or to ‘protect the budget rate’, it is this catalogue-based pricing setup that they typically have in mind. And it is to this model that our attention is directed in this series of blogs.
Understand the catalogue-based pricing model
The salient feature of catalogue-based pricing is that an item that is purchased at the start of the year can be purchased at the same price in the latter part of the catalogue period. When analysing this pricing model from the FX point of view, two key elements need to be considered:
- the ‘FX cliff
- the notion of pricing risk
Borrowed from geography, the term ‘cliff’ plays a determining role in budget-based FX risk management. An FX cliff denotes a sharp movement in the exchange occurring between two budget periods. Recent examples of such cliffs include GBP-USD (September 2022) and USD-MXN (June 2024):
For a company with a high proportion of foreign sales, a sharp appreciation of its functional currency between budget periods is akin to an ‘FX cliff’. This is the case of Swiss watchmaker Swatch, a firm that suffered a CHF 500 million drag on revenue on account of the strong CHF in 2023 [see].
The same could be said for a company with exposure on the contracting side when its functional currency depreciates between budget periods.
Accepting the cliff
Can the company pass on the impact of such currency market moves to its customers at the onset of a new budget campaign/period?
In other words: do its customers ‘accept’ the cliff? If they do, then the firm needs to protect the FX rate that it uses in pricing during each particular campaign/budget period.
This is the case, among many others, of French luxury company Hermès. The firm hiked prices by an average 7% in 2023 in response to the weakness of some Asian currencies vis-à-vis the euro. Price increases were in the double digits in Japan on account of the 23% appreciation of EUR against JPY in 2024 and 2022.
Pricing risk: an under-appreciated ingredient in budget hedging
Pricing risk is defined as the risk of an adverse FX rate fluctuation between the moment a price is set and the moment a firm sale/purchase order is signed. Consider the catalogue-based pricing model. For transactions that occur in the early part of the budget period, this time lapse is very short.
Pricing risk, however, has more of an impact towards the end of the budget period, as a large and unfavourable FX fluctuation may take place while the firm maintains prices unchanged. Such fluctuations can easily wipe out profit margins.
When management infrequently adjusts prices —for example, at the onset of a new campaign— it needs other tools, such as an FX hedging program, to protect its profit margins. This is precisely the topic of this series of blogs.
Goals of FX hedging programs for individual campaign/budget periods
As it considers embarking on an FX hedging program, currency managers need to thoroughly assess the pricing characteristics/parameters of the business. This is why at Kantox we lay such emphasis on this matter.
In upcoming blogs, we will describe in detail:
- What companies get wrong as they hedge their budgeted exposure during individual periods
- What best practices indicate in terms of setting and protecting the budget FX rate
- The automation requirements of such programs.
Before deep diving into these topics, however, it is important to state the primary and secondary objectives —and possible constraints— of an FX hedging program designed for individual campaign/budget periods:
- Principal objective. Protect the FX rate used in pricing.
- Secondary objectives. Optimise forward points, address forecast accuracy, set appropriate risk tolerance levels.
- Possible constraints. Degree of forecast accuracy, maximum trade length authorised by banks.
