Should small businesses get into hedging?

Alpari’s CEO on how small companies can gain the most by getting involved in hedging
By Iskandar Najjar
Mon 01 Oct 2012 09:54 PM

Many months of continued economic and political turmoil in the global economy has led to highly volatile currency markets. This has impacted everybody in various diverse lines of business but particularly badly hit have been some organisations conducting business across borders. Where big conglomerates are dealing in volumes that are able to bear this burden, such shifts in currency may make the difference between profitability and bankruptcy for small to medium enterprises (SMEs) such as import-export companies, farmers, jewellery retailers and other small businesses.

The first thing to do is delve into the process of hedging, the benefits and how to put a hedging strategy in place, all the while giving a broad overview of hedging, before delving into the specifics and potential forex and commodities trading tactics that can be employed to positive effect by small businesses.

Firstly, let’s put the current situation into context. Events in the global economy over the past few years have led to significant volatility in the currency markets, which has subsequently affected the profitability of many companies doing cross-border business.  Currency volatility has become a particularly critical issue, not only in the struggling euro zone, to businesses such as import companies that are purchasing goods or services from overseas in one currency and selling at a later date in their local currency. Business leaders that do not address the issue of currency fluctuation are putting their business at risk.

The continued uncertainty that remains around the outlook for the rest of 2012 means that volatility is likely to prevail in global currency markets. Businesses, particularly SMEs, should be taking this opportunity to put strategies in place to proactively manage this issue and counter this risk.

At Alpari, a global forex and commodities broker, we are keen to use our expertise in our field to provide businesses, such as import agents, with the understanding and tools to navigate their businesses through this challenging time, by providing insight into how hedging currencies against regular commercial transactions can help mitigate risk and maintain operational profitability.

What is hedging?

Put simply, hedging involves making an investment to reduce the risk of adverse price movements in an asset. Normally, a hedge consists of taking an offsetting position in a related security, through something like a futures contract. For instance, a good example of hedging is when you own stock in a certain company; you can then enter into a futures contract stating that you will sell that stock at a set price, thereby avoiding or moderating any market fluctuations. Investors use this strategy when they are unsure of what the market will do. A perfect hedge reduces your risk to nothing (except for the cost of the transaction fees).

In this case, for traders such as import agents, hedging is a tool that allows companies involved in cross border, international trade to protect their regular business transactions against currency and commodity price changes.

The employment of a hedging strategy allows companies negotiating deals in foreign currencies to plan for potential future mid-transaction shifts in exchange rate, by locking in the price of a product which will be delivered in the future and thus locking in margins in advance. In essence, it is like having an insurance policy against rising prices.

Hedging can be executed through several different tools, including forwards, futures, swaps, options and collars, but primarily forwards and futures.

Hedging limits risk

So what are the benefits of forex trading to SMEs and importers? Why can it be so important? Well, firstly hedging limits risk rather than creates risk. It is important to point out that although hedging is not 100 percent failsafe, with the correct guidance, it is a way of reducing risk significantly. Importers can derive tremendous value by seeking hedging opportunities through the use of forex forwards and futures.

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As we enter 2012 from a particularly tumultuous year in 2011, companies trading with the woe-stricken euro zone, who trade in Euros, should certainly consider hedging as a strategy to reduce their exposure to currency fluctuations and reduce risk at a difficult time.

Similarly, companies trading out of India suffering from a struggling Indian Rupee (‘INR’) should also consider hedging as a viable option — especially if their trades involve US Dollars. The Indian Rupee continues to fall to all-time low levels and given the tradition and volume of trading between the UAE and wider GCC and India, businesses reliant on a strong Rupee might look at hedging as a way of softening the blow of a poorly performing currency.

Aside from the Indian Rupee, the performance of the Iranian Riyal, which has plummeted in value largely due to the trade sanctions, has also put traders under severe strain. There is a rich history of trade links between the Gulf countries and Iran; arguably if traders had hedged they may have been able to absorb some of the damaging effects on people’s livelihoods caused by the freefalling currency value.

Aside from currency pressures, extremely high levels of some commodity prices mean that companies can no longer ignore the currency issue in their procurement systems and processes.

Hedging can help manage costs relating to things such as fuel and raw materials and ultimately, hedging drives a fuller bottom line, increasing profitability.

Hedging on limited resources

Hedging strategies can be put in place by investing a smaller percentage of the total amount to be covered through leveraging; this is known as ‘trading on margin’. This means the total investment required to cover $500,000 may only be $5,000 based on a leverage ratio of 1:100. However, it should be noted that there are risks involved in leveraging. For example, if the market moves against you, there must be enough in your reserve funds to cover the margin payment if you need to close out of your position.

If you do not have funds that exceed this, the broker or platform may automatically close your position, leaving you with a loss.

Hedging mitigates risk brought about by volatile prices and last year, we have seen global commodity prices move drastically through uncontrollable market risk which can drive currencies and commodities in rapidly changing different directions; hedging can help soften the blow brought about by exposure to such extreme external factors.

Up to this point, a lack of knowledge and understanding and a degree of fear of what is perceived to be a complex subject has contributed to hedging not being embraced by smaller companies and SMEs in particular.

In conclusion, the most crucial aspect of a forex hedging strategy is to understand the risks that could affect your business. Initially, owners of SMEs need to identify and evaluate the risks the company is exposed to, which will differ depending on the industry.

The next step a business owner should make is to define their risk tolerance, which will in turn inform the company’s forex hedging strategy, which at such a turbulent time, could mean the difference between profit and loss.  Never have we witnessed such a time as in recent years, where hedging can simply make or break a company.

Iskandar Najjar is the CEO of Alpari ME DMCC.

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