Exchange rate

Hedging with Derivatives; Part 2 of 3: Interest Rate Risk

If variable interest rates leave your company exposed, you should consider an interest rate hedging strategy.  The most common method is a ‘vanilla’ interest rate swap which can be used to effectively convert all or part of a variable (LIBOR + X) rate loan into a fixed rate loan, thereby mitigating the risk of fluctuating exchange rates.  Simple example:  You have a $2 million loan that pays a variable interest rate.  You can enter into a swap agreement whereby you will borrow $1 million at a fixed rate and invest it in a security that earns a variable rate.  This will reduce your exposure to fluctuations in the variable LIBOR rate.

Another situation that may necessitate an interest rate hedging strategy is when you are anticipating a significant inflow or outflow of cash to take place in the future, perhaps one year from now.  The viability of the strategy may depend to some degree on the interest rate at that time, and you do not know what that interest rate will be.  By purchasing a Treasury futures contract, you could effectively ‘lock-in’ the interest rate now.  This will take one important variable out of the equation and make it easier to focus on the other aspects of the deal.

As with other types of hedging, remember the purpose of a hedge program is to mitigate risk.

Next up:  Hedging with Derivatives; Part 3 of 3:  Commodity or Product Input Risk

Hedging with derivatives Part 1 of 3; Foreign Exchange Risk

When a middle market company engages in exporting its products or importing raw materials, it may want to consider hedging the risks related to fluctuations in the currency.  For example, let’s assume your company takes a sales order from a French customer that will be filled in 6 months and you agree on a price in Euro’s.  You know exactly how many Dollars those Euro’s will convert into at today’s exchange rate.  The problem is you don’t know what the exchange rate will be 6 months from now when you get paid.  If the Dollar appreciates versus the Euro, you will end up with fewer dollars than you anticipated when you booked the sale.  To mitigate this risk, you can purchase foreign-exchange futures contracts.  I will not get into the details of how those work, but I will offer these additional tips:

  • If you agree to terms with a customer or vendor involving foreign currency, define the currency and stick with it.  Do not allow the customer/vendor to have their choice between a price in Dollars or the foreign currency.  Doing so would allow them to complete the transaction in whichever currency is favorable to them at the time of payment, which means your company is shouldering all the risk and will likely lose either way.  Make sure your salespeople, AR and AP staff’s understand this and monitor it.
  • As an alternative to hedging, you can structure the sale or purchase contract in a way that shares the risk between the customer and the vendor by locking the current exchange rate on a portion of the total contract.
  • Some companies have a natural hedge, meaning they purchase raw materials in a foreign currency and then sell finished goods in the same currency.  The idea is fluctuations in the currency that drive raw material prices up will also result in higher sales and vice-versa so there is less need for a hedging strategy.  However, due to timing differences, you might think you have a natural hedge but what you really have is twice the exposure and you could actually lose on both ends!
  • Isolate your gains/losses on foreign currency exchange from your other revenue and material costs.  Make it one of the KPI’s you include in your reporting package.
  • Remember, you are not a speculator.  You are a risk mitigator.  If your “hedging” strategy actually makes a lot of money for the company, you are not doing it right.

Next up:  Hedging with Derivatives Part 2 of 3; Interest Rate Risk