By Bernard Hickey
Small to medium businesses thinking about foreign currency risks in their business often think a lot about where the currency is headed to try to second guess the best thing to do.
However, Kiwibank's Head of Financial Markets Nigel Gaudin says SMEs would be better stepping back to think about what those risks are for their cashflows and profit, rather than trying to pick currency movements.
"If you want to speculate on the currency, that's fine for you, but call it for what it is, and keep that seperate from your business," Gaudin said in a recent Double Shot interview with Interest.co.nz above.
Before jumping in to pick a currency movement, a SME should work out its cash flows and its break-even points to understand what currency movements would do to profits so it can hedge those risks if they're big enough, he says.
"The currency is very volatile. With money printing in the United States, currency controls in China and the fallout in Europe, it's not easy to forecast where the New Zealand dollar is going to go against the US rate, let alone the pound or the euro or the yen," he said.
There are plenty of variables to think about besides the exchange rate, including when cash flows are timed and how long before a product or service is produced, imported, exported and sold.
"It does depend on the timelines you're dealing with, because if you're not looking to import something for 12 months then the currency effect on that could be quite large. If you look at how the currency moved in the last 12 months then against the US dollar you could easily be paying anything between 75 and 86 cents. A 10 cent move is quite material," he said.
Any business owner had to take into account their cash flows and their risk appetite when assessing whether and how to hedge, Gaudin says.
Questions to ask include:
- What is my cash flow cycle?
- When does my currency exposure begin.
- What is my end-to-end cash flow cycle
- How risk averse am I?
- Do I want to cover my exchange rate risk?
- Or is it not that material to me at the end of the day?
- Where is my breakeven point on my import or export?
- How much does it cost me to produce it?
- Where does my breakeven rate come in? When do I start losing maoney?
"You've got to do all that sort of stuff before you then start thinking about what's out there and how do I start managing that risk."
How to hedge
Gaudin says any business thinking about how to hedge their risks should get in touch with their bank.
"We get alongside a lot of customers to see where their business sits and helping them manage their exchange rate risk. We would sit down with a client to look at what their time frames are. Do they want to use a spot forward exchange contract or a forward exchange contract? Do they want to buy the currency outright and put it in a foreign currency account?"
Other ways to hedge include foreign exchange options and more complex tools such as foreign exchange loans or foreign currency overdrafts.
Ultimately, there are two ways for businesses to think about their foreign exchange needs, Gaudin says. Either a business owner can choose to hedge, or to speculate.
To hedge or to speculate
Firstly, a business can go through its cash flow cycles, work out where its costs are and figure out what its risk appetite is. Then by hedging a business can take any thoughts about picking currency movements out of the equation.
"By covering the exchange rate risk they can guarantee they will hit the margins they expect to and therefore the profit should fall out of the business accordingly. To do it otherwise is purely speculation," Gaudin says.