Andy Scott, associate director of JCRA explains how to cope with currency swings
As the travel industry looks ahead to the next holiday season, many face the annual challenge of setting prices for 2019.
This is more daunting this year after a summer of significant volatility in foreign exchange rates as a result of Brexit uncertainty, the ‘US first’ narrative of President Trump and emerging markets unrest.
We have seen an increasing number of travel companies looking to re-evaluate their foreign exchange exposures and either start a hedging programme or add to existing hedges.
While experienced finance directors and chief financial officers in the industry are accustomed to the increased volatility that comes with managing multiple currency baskets, it’s fair to say that 2018 has been quite extreme.
Sterling’s rise of 100% against the Turkish lira and 70% against the Argentine peso are just two examples.
Fortunately, due to the volatile nature of many emerging market currencies, many local contracts are priced in US dollars or euros, predominantly to protect local business from domestic currency depreciation.
However, it is not possible to eliminate the local currency risk and there is still the foreign exchange risk from the euro or US dollar to consider.
Against this backdrop, one piece of advice to travel businesses is don’t leave it to chance.
It is a difficult judgement call and many CFOs we work with argue that making a hedging decision which goes wrong is worse than not hedging at all.
But we disagree – not taking an active approach to risk exposures is still an active hedging decision.
Unless your business has complete flexibility to adapt pricing frequently, has large enough profit margins to absorb negative currency fluctuations or has perfect flows of currency that naturally offset themselves, you should be hedging against foreign exchange risk.
We also emphasise that hedging does not have to mean fixing all your forecast exposure.
FX hedging strategies
Typically, hedging foreign exchange (FX) risk involves using forward contracts but also some derivative products that offer greater flexibility.
Companies which have the flexibility to pass on FX rate changes through their pricing tend to hedge only once they have the certainty of a customer booking. This approach has the benefit of only hedging realised risk.
Those companies which don’t have much flexibility to change prices or which prefer to operate on a fixed-rate basis tend to place hedges for forecast bookings up to 12 months ahead.
This has the benefit of greater certainty over potential revenue and avoids having to increase prices when sterling depreciates.
However, this may force companies to accept lower margins if sterling appreciates to compete with those whose pricing can be more flexible.
The cost of a hedge can be considered in different ways. The ‘opportunity cost’ is important if hedging means the business cannot benefit from a favourable movement in the rate.
The difference between the current ‘spot’ rate and the ‘hedged’ (forward) rate needs to be considered, as do the transaction charges imposed by the hedging counterparty.
The execution of an FX hedging programme might require the setting up of a credit agreement with a counterparty, which means collateral (cash) might be needed to support the hedging position.
The accounting treatment also needs to be considered and should be an integral part of the overall hedging strategy. This is a complicated area and you don’t want any surprises at reporting time.
To illustrate the difference between a ‘spot’ rate and a ‘hedged’ rate we took the forward exchange rates for sterling (GBP) versus the euro (EUR) and sterling versus the US dollar (USD) on October 19 and calculated the percentage discount or premium.
To exchange GBP into EUR on a forward contract for 12 months the premium was 1.44%. To exchange GBP into USD on a forward contract for 12 months, the discount was 1.96%.
The premium or discount reflects the interest rate differential between the currencies.
It’s almost impossible to eliminate FX risk entirely, but we don’t believe that should be the objective. The optimum is a well-considered, properly executed strategy that meets the needs of a business.
We work with many chief financial officers concerned about the precision of their forecasting, who sometimes decide to do nothing.
We work on the premise that it is better to get it broadly right than exactly wrong. Simple hedging strategies can be designed to achieve this.
You would not be comfortable for your customers to go on holiday without taking out travel insurance, so why leave your business unprotected from foreign exchange risk?
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