Sunday, August 30, 2009

Currency Hedging?

Photo Credit: Tracy Olsen

Commenting on our last post, Matt raised an excellent issue about currency hedging which I think warrants it's own post. Neither Mike, Jodie nor myself have worked in finance so I'd love to hear people's thoughts on this.

Currency hedging for us would essentially mean locking in a Hong Kong to Australian dollar exchange rate. We pay for our shoes in Hong Kong dollars but receive payment from our customers in Australia dollars. So if the Hong Kong dollar rises in value against the Australian dollar, our costs go up but our revenue doesn't = bad times. On the flip side, if we hedge, we would lose any benefit if the Hong Kong dollar falls in value against the Australian dollar. Hedging helps mitigate risk.

Here are my thoughts on hedging:

1. In the short term we can't really hedge as we have no idea what our revenue is going to be like and therefore how much we should hedge. Hopefully this is only temporary and we have a better idea in a few months time following our launch.

2. If the Australian dollar moves in value against other currencies, our competitors will be faced with the same issues as us as very few shoes are made in Australia. If the Australian dollar rises in value we, and our competitors all benefit from higher margins. However this is likely to attract new entrants to the market pushing down prices, so the net effect after a period of time is neutral. If the Australian dollar falls in value against all currencies, we and our competitors face decreasing margins putting pressure on us all to raise prices. If everyone raises their prices then, assuming demand doesn't slacken off too much at the higher prices, the net effect after a period of time is neutral. There are a ton of assumptions in here, including that our competitors don't hedge, which I think is likely given the shoe retailing market is made up of many small players.

3. We don't know which currencies our competitors buy their shoes in and the theory in point 2 above doesn't hold if most of our competitors buy in Chinese yuan or US dollars. If they do then we're at risk if the Hong Kong dollar appreciates in value against the Australian dollar, but the Chinese yuan and US dollar don't.

4. Hedging costs money. I'm guessing in the order of a couple of percent of the value hedged?

Conclusion - Given these points I think we need to:
1. Launch so we get an understanding of what our sales are going to be.
2. Find out what currency our competitors buy their shoes in.
3. Consider some hedging as the market movements described in point 2 above take time to happen. Hedging might help us in the short term until the market adjusts.

Thanks for bringing this up and making us think this through Matt! I'd love to hear yours and anyone else's thoughts on hedging as it's a long way from our area of expertise. (Feel free to comment below).

12 comments:

  1. Hey mate,

    A few thoughts:

    - I believe that the HKD is pegged to the USD, so you can probably hedge into USD or buy in USD and get the same effect

    - how much margin have you got to play with? Buying in USD is a pretty common thing for importers to do and chances are some hedge and some don’t. At some level or point in time, you are going to have to pass on increases (or decreases) in your cost base to your customers. Have you got a good handle on your fixed and variable costs between the factory floor and the customer? And the comparison to say a typical shoe retailer?

    I like your wait and see approach. There are lots of moving pieces and flexibility is probably the name of the game!

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  2. Hey Michael - a couple of thoughts:
    1. You're right - it's hard to hedge in the early days
    2. Transactions are hard to hedge against for the longer term
    3. Short term hedging - If you know you have a large shipment due in 2 weeks (for example), and the Aussie $ to HK $ dollar is going strong, but the currency early. This means outlaying more funds earlier than needed... which can be a cash flow drain.
    4. Start monitoring the HK currency to determine averages and performance (like shares)
    5. Know your transaction costs with the bank - they are costly.

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  3. I think you will end up destroying value trying to hedge, given the fact you are not a currency trader. If you have any power with your supplier (i.e. they are small) you could write a pain share / gain share clause into your supply contract, spreading some of the risk across both parties. That is assuming you are on contract.

    Another option would be to index your pricing based the fx value, given it is a web business it is really easy to change your pricing. Although you would want to do this in neat increments. You could also build some contingency into your pricing

    The third option is to fix price the supply contract at current market prices, they wear all the Fx risk.

    either way you go, I think hedging is a bad idea in the long term, as you just end up wearing the hedging costs, for the same long term result. A lot of big companies have got out of trading for this reason. I would only think about hedging if you need to guarantee a price for a large one off future purchase.

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  4. If your FX trade sizes are large enough, you shouldn't have to pay away too much to hedge. Of course it will be impossible to hedge infinitely into the future.

    Another thing to think about is the correlation of the broad market to the USD. When the equity market slumps (and the overall economy too), investors flee to the safety of the USD pushing its value up as measured in other currencies. If your costs are in HKD(essentially USD), then when things get bad for the economy, and people buy less shoes, you might find that you are double hurting, unit sales down in AUD and costs per unit up in AUD terms. (Or perhaps this is the best scenario for you guys, as you will be the alternative low price seller and your sales will rise - recession proof).

    I think that FX variability is one of the main reasons why everything is SOOOO expensive in 'striya compared to the States (of course the US has advantage of volume too). It seems that standard goods (sourced in the US) have a >30% markup when compared in the same currency as they sell for in the states. Tax and shipping explain some of it, but I have the feeling that vendors have a look at the exchange rate, and add a buffer, and don't hedge.

    Mike, I think you are right that you need to wait and see. Most of your uncertainty probably revolves around the sales side and not the FX side. What's your best guess 90% confidence interval for unit sales? The market will tell you how much it expects the exchange rate to move (1yr AUDUSD volatility is 15% so ~90% probability that the USDAUD will be between 0.60 and 1.10). As long as the extreme scenarios are tolerable, you probably don't need to hedge until the other non-hedgeable variables are stable.

    ~MR

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  5. Hi all, great thoughts here, thanks for all this.

    Matt - thanks for pointing out the HKD to pegged to the USD, I didn't know that. I found out it's pegged but allowed to move between a lower limit of 1USD=7.75HKD and 1USD=7.85HKD.

    Mat - great thoughts on short term hedging for large, one-off transactions. Perhaps we could set up a HKD bank account with a good interest rate so we could transfer money early to lock in an exchange rate, but still earn interest on the money.

    David - great thoughts on locking in exchange rates via contracts with our supplier once we're in a position to negotiate that. And I agree that hedging in the long term, when there are transaction costs involved, doesn't really make sense.

    Matt - Thanks again for your thoughts on this one. Interesting point about us potentially being doubly hurt when the economy takes a downturn. The volatility measure you mention is a very interesting one. A move to an AUDUSD exchange rate of 0.60 would certainly hurt our margins. Is there any easy place to see that volatility measure online? Just had a look on Google Finance and couldn't see it there.

    So it sounds like we need to do a bit more research to understand how our supplier deal with this, to fully understand our own cost base and to keep an eye on the AUD to USD/HKD exchange rate. Once we're across all that we should at least consider some short term hedging for larger one-off transactions, but keep our mind open to other options as well, depending on what currency markets do and what we can negotiate with our supplier.

    Thanks again all.

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  6. www.newyorkfed.org/markets/impliedvolatility.html

    has a nice little table for vols against USD

    MR

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  7. Great problem to have - sell some shoes first! then you should speak to ozforex, they do currency transfers for HK, AU and lots of other markets. We use them for all intl transactions, saves us a lot of money as they seriously undercut retail banks. weren't they a client of yours foxy?
    speak to jacob 02 8667 8090 tell him i sent you as i get referrals.
    Keep it up
    Bails

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  8. and ozforex re 50% owned by Mac Bank too

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  9. Matt - thanks for the link, I'll keep an eye on that.

    Chris - OzForex looks awesome, much lower fees than the banks. We don't have any transferring to do right now but I'll give Jacob a call and tell him u sent me when we do. Cheers.

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  10. Mike's behind the Great Firewall of China at the moment so can't access the blog to comment. So he sent me an email to say that a few days ago (prior to your comment about ozforex Bayles) he signed up to www.latitudegt.com to do an international transfer and said it was awesome. Low fees and really easy to do.

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  11. I am sooo glad this topic came up, but apols for taking ages to comment...I've been on holiday!

    So hedging is fascinating and intriguing. For the sake of your business, its size and your model, I'd lump hedging under the wider topic of risk management and volatility. Some new ventures take this topic to the nth degree, as volatility is bad for business. You want to stabilise your costs and correlate them where possible to your revenue, and currency fluctuations can obviously affect that.

    But when talking about the wider risk management and how you approach these risks in the business, it is certainly worth remembering that risk is also opportunity, and its where most of your margin will lie as a new vendor.

    You also have to remember that there is only so much you guys can do, and that prioritising on the key differentiators in your business model is still vitally important. It's easy to get carried away on the learning curve to save a few bucks in a sale, when you might not have the sale if you don't pitch it right.

    All I would encourage you to do is to take tactical and strategic risks, as there are many more lurking out there other than just currency risks, some of which were mentioned in other comments.

    Good luck in China and catch you when you get back.

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  12. Now then, after my oats this morning, I had another thought. I used to work with a guy who worked on a principal called intelligent pricing. Instead of focusing of potentially distracting operations that are non-core (hedging), you instead take your entire risk profile for the business that you can't directly 'manage' and you factor it into your pricing.

    Its the same principal, as you are looking to take the volatility out, and placing the risk (straight $ values or % movements) into the pricing to give you a true margin. You can use it for allsorts, such as shipping costs, transaction costs etc...

    You wouldn't want to lump everything into your risk factor pricing, as you'd be selling all your shoes at $1,000 "just in case", but I think there is a healthy exercise in looking at what you can manage as a new start up, and the things that you are just exposed to given the nature of the business you are in.

    I think it might be worth considering as your business plan shows that you are quite niche in your area and you don't feel overly price sensitive, which should help?

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