Reason #1: Certainty of results
Many management teams are incentivised to ensure a particular outcome relative to a budget or forecast. These companies hedge to add certainty around what value of foreign revenues and/or expenses they will report .
For example, if revenues are contractually agreed in dollars but expenses are denominated in GBP over the next 12 months, management may choose to lock down the value of each USD sales contract with an FX Forward to deliver the budgeted results and expected profit margins.
Reason #2: Delay impact & provide time to pivot
Some companies hedge forecast cashflows to delay the time until a currency rate change causes impact, and thus giving them time to pivot. The farther out a company hedges, the longer the delay before they experience changes in currency rates. Hedging out 12 months each month means that the rate experienced in the market today will not impact earnings for 12 months.
For example, if foreign currency operating expenses are hedged out 12 months and the Company observes foreign currencies strengthening, they have 12 months to plan operational changes to bring those expenses in line with GBP revenue. On the revenue side, if foreign currencies weaken, hedging of foreign contracts can ensure the Company has time before needing to raise foreign prices to meet margin targets.
Reason #3: Smooth rates
Companies will often hedge to “smooth” or “average in” currency rate impacts. Without these hedges, all activity in a month is recorded at the “current” rate. If 100 percent of a company’s revenue is booked in foreign currency between November and December, management may not be willing to wait and see where the accounting rates land.
Companies will often layer in hedges to achieve a desired amount of averaging so exchange rate impacts are muted. It also allows the business to budget more effectively given they know the average exchange rate for a large percentage of future revenue.
Reason #4: Stakeholder demands
Investors may penalize companies that haven’t appropriately managed foreign currency risk and a lack of control of currency fluctuations often reflects poorly on the management team.
Board members with experience at larger or more sophisticated companies may often introduce the benefits of hedging to their fellow Board members and management. Occasionally this precedes an FX surprise, but if not will generally follow quickly on the heels of one.
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