SMEs: 9 tips for improving your hedging against currency risk

An inherent feature of all international foreign exchange transactions, currency risk puts pressure on your company’s profit margins.

Owing to its geographical proximity to the European Union (EU) and the global reputation of certain sectors of its economy (luxury goods, pharmaceuticals and electronics), Switzerland is home to a large number of SMEs whose turnover derives largely from exports.

As a result, currency risk regularly erodes the margins on these international sales. However, there are solutions available to adapt your sales process with the aim of minimising this loss and safeguarding your profits!

#1 Understanding the different types of foreign exchange risk

Although frequently used in the context of international trade, the term “currency risk” is often subject to a great deal of misinterpretation. 

Indeed, any commercial transaction involving the purchase or sale of goods between two parties from different countries exposes the parties involved to various foreign exchange risks, namely:

• Transfer risk: this refers to the risk that the government of one of the parties might implement a policy preventing any international currency transfers;

• Convertibility risk: this refers to the risk that the government of one of the parties will refuse to sell any currency in the form of loans or bonds;

• Transaction risk: this is the risk that the currency will appreciate or depreciate between the date of invoicing and the date of payment;

• Economic risk: this refers to the risk that the foreign exchange market may affect a product’s structural profitability by reducing the value of its revenue and/or increasing its costs.

In this article, we will focus on the latter two types of risk (transactional risk and economic risk) in order to minimise the losses that could result from a potential appreciation or depreciation of currencies.

#2 Understanding the source of foreign exchange risk

Because the sales process involves numerous stages (quotes, invoices, payments, etc.) and the exchange rate between two currencies in an international transaction fluctuates over time, the prices quoted at the time of invoicing are subject to often unpredictable variations.

It is therefore to protect themselves against this volatility between the Swiss franc and any other currency that Swiss sellers may find it beneficial to adopt a solution tailored to their foreign exchange needs.

NB: Although profit margins are subject to uncertainty due to fluctuations in exchange rates, hedging against currency risk involves variable costs. It is therefore essential to start by asking the following question: Is it cost-effective to put a currency hedge in place?

#3 Contact the right person depending on your foreign exchange needs

Depending on the complexity of the foreign exchange transactions you wish to carry out, the value and frequency of your transactions, and the type of solution you are considering, the ideal point of contact will vary.

Banks are the traditional intermediaries for any foreign exchange hedging transaction. As foreign exchange risk is a familiar area for properly trained bankers, banking services generally inspire confidence.

However, this solution involves a number of administrative constraints, including:

• opaque pricing;
• often high costs (management fees, premiums);
• reduced accessibility;
• delays that are sometimes too long;
• exchange rates that are sometimes out of touch with market realities.

Currency brokers therefore represent an attractive alternative, particularly in terms of ease of use, as the advent of the internet has enabled them to operate online, often at much more reasonable rates given that their cost structure is streamlined – as is the case with the online currency exchange service b-sharpe.

#4 Start trade negotiations with your counterpart

Whilst, as a general rule, the buyer’s payment is made in their national currency, it is entirely possible for the seller to require payment in their own currency.

However, such an approach transfers the entire foreign exchange risk to the buyer. To be able to negotiate on these terms, it is therefore advisable to have a strong sales pitch, for example:

• to hold a monopoly position in the market;
• have unique and irreplicable competitive advantages;
• offer extremely low prices that offset any currency risk for the buyer;
• maintain a strong relationship of trust with the buyer (long-term customer loyalty policy).

Apart from the radical nature of such a stance, negotiation is a fundamental process for distributing and balancing foreign exchange risk between the two parties as effectively as possible.

Please note: Whatever decision is taken, negotiations on the sharing of foreign exchange risk between two companies are a sensitive matter, as they will inevitably result, in the long term, in one party gaining and the other losing, depending on exchange rate movements.

#5 Agree on indexation clauses in advance to hedge against currency risk

With a view to agreeing on the measures to be taken in the event of a change in the exchange rate for the currency pair between the buyer and the seller, the parties may agree on various clauses, some of which may be more or less advantageous to one or the other party:

• The price adjustment clause: this involves passing on the full cost of exchange rate fluctuations to the buyer, in line with the advice given earlier. This option clearly favours the seller;

• The multi-currency clause (multiple currency clause): this involves stating the invoice amount in several currencies. The party designated in the contract selects the currency of their choice upon maturity. This option benefits the party designated as the decision-maker;

• The tunnel indexation clause: this involves fixing prices prior to payment, provided that exchange rate fluctuations remain within a ‘tunnel’, i.e. between a minimum threshold and a maximum ceiling. Beyond these limits, exchange rate risk will affect pricing;

• The currency indexation clause: this involves setting the price in relation to a third-party benchmark (such as a less volatile currency) in order to enhance exchange rate stability;

• The currency basket indexation clause: this involves the same process, but with values pegged not to a single currency but to a basket of currencies such as the SDR (here too, this reduces volatility as well as currency risk);

• The currency option clause: this involves setting the price in relation to a third-party benchmark; however, in this case, the choice is made by one of the parties prior to each transaction;

• The risk-sharing clause: this involves both parties agreeing in advance to a specific percentage allocation of the foreign exchange risk (for example, 50% for each party).

#6 Opt for a third-party currency and play the neutrality card

There are several reasons why parties might choose a third currency to act as an intermediary between the two national currencies. These may stem from a commercial agreement between the buyer and seller, or from constraints imposed by the government.

Indeed, some countries’ laws require the use of the national currency for all transactions carried out within their borders. Similarly, certain geographical areas may be particularly conducive to trade, for example in the context of import-export activities across multiple regions. In some cases, certain countries do not even have a foreign exchange market: it is therefore necessary to go via a third country.

Please note: Such a decision brings the concept of cross-currency risk into play, which, whilst it may sometimes be convenient for all parties, complicates the process of currency hedging.

#7 Enter into a cross-currency swap to maintain a balance of payments

Literally speaking, a currency swap involves an initial exchange of foreign currencies (the amount of which is mutually agreed) between the two parties, each of which undertakes to pay the other interest at predetermined intervals. Upon maturity, the two companies finally agree to return the stipulated amount to one another.

Good to know: A currency swap can be described as a parallel loan between the two companies.

Exporters, for their part, are eligible for an export swap; that is, an advance in convertible currency granted by the Central Bank. This advance is repaid by the exporter once payment has been received.

#8 Setting up a subsidiary abroad to tap into the most profitable markets

Depending on the circumstances, high production volumes or turnover may justify a company setting up a subsidiary in the target country. Although this is a complex and costly process, it can enable the company to pass on the foreign exchange risk to its subsidiary rather than to the parent company.

When the volume of goods exported to a foreign country becomes sufficiently large, it may be cost-effective to transfer some of your expenses and income to a local subsidiary. Such a legal arrangement is, for example, entirely feasible between Switzerland and the EU.

However, there are certain points that need to be clarified in advance, namely:

• your company’s profitability and growth objectives;
• the culture and professional practices of the target market;
• the legal form of the entity to be established locally;
• the network of potential partners to contact locally;
• the members of your team who are likely to work abroad.

#9 Manage your cash flows to minimise the amount exposed to foreign exchange risk

By internationalising your production and sales activities, you can implement a netting policy. This involves offsetting the inflows and outflows of your overseas subsidiary in order to reduce the balance exposed to foreign exchange risk.

In practical terms, the parent company’s debts can be transferred to your subsidiary when foreign currencies are strengthening against the Swiss franc, in order to offset revenue generated abroad (thereby reducing the associated foreign exchange risk) whilst relieving your company of these liabilities.

The key, then, is to make the most of favourable exchange rate movements in your currency pairs in order to maximise the value of your foreign exchange transactions. This technique of timing foreign exchange transactions is known as ‘termaillage’.

Please note: This approach is both complex and time-consuming; therefore, the benefits of deferral must always be weighed against the cash flow constraints it entails.

Consolidating orders and payments allows for better control over cash inflows and outflows, whilst reducing the number of transactions to manage. This will enable your business (and the banks) to optimise both its hedging against exchange rate risk and its cash flow management.

You now know nine ways to manage your production and marketing processes in order to reduce the foreign exchange risk associated with your company’s international transactions!

Please be aware, however, that there are other, more technical methods available for optimising your hedging against currency risk, which will require a degree of involvement and expertise in the foreign exchange markets.