Discover essential FX hedging strategies and currency management best practices from our foreign exchange experts.
Set the budget rate like a champion
Budget season has arrived! In this article, we show you the best practices for treasurers and CFOs when they set a budget rate.
The budget rate is the foreign exchange rate that is used when setting prices at the start of a budget period. For example, a firm that buys key inputs in USD and sells final goods in EUR may set the price by using the EUR-USD rate to arrive at the cost of sale in EUR. Many firms conduct more than one campaign per year. If so, the FX to protect should be the rate of each individual campaign rather than an annual budget rate. When setting the campaign/budget rate, some common practices include:
- the spot rate
- the forward rate
- an off-market rate
- a market-consensus rate
Best practices: the built-in budget rate
Instead of defining a budget rate first and then applying a hedging program to protect it, some companies hedge the forecasted exposure beforehand, building the FX rate used to set prices.⇒ Advantage: the campaign/budget period that gets underway is already protected against currency riskX Disadvantage: with a locked-in FX rate, competitors who hedge later may profit from better market conditionsX Disadvantage: the built-in budget rate presupposes a high degree of forecast accuracy, a luxury that not all companies can afford
The best of the best practices: protecting a ‘worst-case scenario’ rate
There is a much better approach. When the budget is created, the finance team sets a ‘buffer’ between the prevailing market rate and a less favourable rate it desires to protect using conditional stop-loss orders.That rate is usually the FX rate used in pricing, but it can also be a ‘worst-case scenario’ rate. This brings up some intriguing questions:
- How is that budget rate calculated?
- How do hedging programs protect it?
- What are the advantages of this approach?
If you are currently drafting your budget, and you need an answer to these questions, make sure to download our free report Hedging the Budget: How to systematically outperform your budget rate.
