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“hedging Strategies For Australian Forex Traders: Protecting Profits” – Currency markets are more volatile than they have been in years. The US dollar is at a 20-year high, and there is considerable geopolitical and economic uncertainty. In response, U.S. companies of all sizes need to reevaluate their foreign exchange (FX) risk and hedging policies. This hedging policy should be consistent with business objectives, keeping currency volatility within a predictable, resilient range so companies can conduct their business with greater operational confidence.
Despite the urgency of the task, this review should be done methodically. Before developing a hedge strategy, some important homework and self-reflection should be done regarding the company’s objectives and risk tolerance. Otherwise, the hedge program will not work effectively. To manage this review process, consider using a four-part framework: Defining Corporate Goals and Objectives, Identifying and Analyzing FX Exposures, Designing and Implementing Hedging Strategies, and Reviewing and Monitoring the Hedge Program (see Figure 1). Once in place, this framework should guide an iterative, ongoing process to continuously refine the hedge program.
“hedging Strategies For Australian Forex Traders: Protecting Profits”
The main objectives for companies when hedging forecast transactions can be broadly similar, such as mitigating the impact of FX rates on financial performance, supporting senior management’s ability to forecast financial performance, protecting budget results, improving product/service pricing, and governance. FX risks associated with capital projects.
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But when setting specific goals for a company, one must first identify the firm’s priorities and consider the various trade-offs between those priorities. Priorities and trade-offs may depend on how and where a company conducts its business. If most of a company’s sales are overseas, a stronger dollar will have a negative impact on its finances because there will be fewer dollars to bring those revenues offshore. On the other hand, companies that sell in the United States but buy raw materials from abroad benefit from a strong dollar because it is cheaper to buy these raw materials in dollar terms. In both cases, Forex risk exposes companies to operational uncertainty, but their different business footprints and exposures may lead to different risk management objectives.
You also want to focus on what financial indicators. For example, some companies focus on how currency risk will affect their balance sheet. Currency fluctuations have a direct impact on recorded assets and liabilities, payables and receivables, cash, etc., which are obvious items that need to be explained to shareholders. Thus, a hedge is often intended to reduce volatility in the balance sheet. Another reason to hedge is to reduce the risks associated with projected returns and expectations. In this case, management wants to maintain the viability of its business plan and reduce quarter-to-quarter and year-to-year volatility. A variety of hedging programs can be used to address balance sheet risk and FX risk associated with forecasted revenues and expenses.
To achieve their goals, companies should adopt a risk-based approach to hedging, as opposed to a market-based approach. The objective of the risk-based approach is to reduce operational risk by keeping currency fluctuations within certain tolerance limits. This approach requires a holistic view of the company’s different types of risk and an understanding of how they fit together (ie, how they can increase risk or offset each other).
In contrast, a market-based approach tends to time the currency market. The problem with this approach is that if a company only reverses when it anticipates a negative FX movement, it is exposed to significant FX risk at other times. For example, a large US company with large foreign sales hedges each fall using a market-based approach. In 2021, it decided not to hedge foreign inflows, thinking the dollar was overvalued. But the dollar continued to strengthen, causing significant financial pain from the company. By using this market-based approach, the company did not adequately consider other risks in the enterprise or consider how much Forex risk was acceptable.
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A company with limited international operations may have good intuition about its currency exposure. But as a company begins to expand its operations overseas—to build its supply chain—complexities quickly snowball, making it difficult to understand the scale of the threat and mitigate it. Thus, it is important to regularly analyze how the movement of a particular currency over the next six, 12, or even 24 months will affect a company’s balance sheet, projected cash flow, or planned event. get A key question for managers is what level of negative outcomes can the company tolerate?
Clearly, taking a risk-based approach requires a holistic approach to understanding how all of a company’s risks fit together. For example, a company’s risks may be partially interrelated, partially offset, and may create “natural” barriers. Consider the following hypothetical example of a US-based company with global sales (see Figure 2). If you include individual currency risks (Australian dollar, -12.6 MM; Canadian dollar, -14.9 MM; Euro, -6.4 MM; and Mexican peso, -34.9 MM), natural gas (-88.4 MM) and if you add a percentage. rate risk (-0.8 MM), indicating that net income could be $160 million less than forecast (with 95 percent confidence). But these various risks don’t move very quickly, so adding them up will give you a rough idea of a company’s exposure and hedging requirements. Based on the historical correlations in this example, the diversification benefits are reduced by approximately $60 million, so the company’s portfolio-based exposure is estimated at $96 million.
After you’ve done your homework to understand your goals and analyze your currency exposures, it’s time to develop a hedging strategy. Thus, a well-designed FX hedge strategy in Figure 2 may not include 100% hedging of each of the four currencies, as this may eliminate some of the natural barriers between currency and natural gas exposure. It is better to build a hedge strategy in favor of any free diversification; in the above example, perhaps only parts of individual currency transactions should be bricked. The art and science of designing a hedge strategy is determining the minimum amount needed to achieve a target level of risk while minimizing costs and operational complexity, and understanding the trade-off between the target risk level and the cost and complexity of the hedge. . Identifying strategies that are cost-effective for risk and cost/complexity, the so-called “effective brick bounds,” are often not apparent without in-depth analysis.
Identifying objectives, evaluating currency exposure and developing a hedging strategy is a difficult task that will not work unless a company implements a systematic FX hedging program over a long period of time. That means writing a hedge policy that outlines how the company will perform going forward, including setting new hedges monthly and quarterly.
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The company should not be rooted in currency barriers. It’s not appropriate to say, “We’re out of the money in this hedge, so we shouldn’t be doing this.” Instead, a company should judge whether its hedging strategy has kept currency volatility within an expected, tolerable range over six, 12 or 24 months.
Companies should regularly evaluate their FX exposures and the effects of their hedging programs, incorporating new information whenever possible.
With currency markets more volatile than they have been in years, it is important for companies to re-evaluate their currency hedge programs in the current environment. It’s a daunting task, but a four-part framework can help companies systematically address challenges and ensure the program remains effective for years to come.
Eric Merlis, managing director and co-head of the Global Markets team, is responsible for the interest rate derivatives, foreign exchange and commodity sales and trading groups. He holds an MBA in Finance from Southern Illinois University at Carbondale and a BA in Philosophy from Siena College.
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Securities products and services are offered through Citizens JMP Securities, LLC, member FINRA, SIPC. Citizens Capital Markets, DH Capital, Trinity Capital and JMP Securities – Citizens Financial Group, Inc. brand Note: Any guidelines provided are for the individuals depicted and may not be representative of the experiences of others. Any descriptions are unpaid and do not represent future performance or success. A hedge in trading is a way to protect against potential losses. It is similar to insurance in your trade, which reduces or covers the amount compared to the loss.
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