Currency and interest rate hedging
Acknowledge the risk and manage it
Currency and interest rate risk is defined as absolute amounts in the form of outstanding receivables and liabilities that are subject to currency- or interest rate fluctuations. The risk that weighs on this exposure arises from the uncertainty about the development of the exchange rate, commodity and/or interest rate curve, i.e. the price risk.
These risks can arise transactionally (physically) or translationally (from translations), whereby there is a third component, that of uncertain physical cash flows in the future. This is considered an economic risk.
Application example: You have a EUR credit balance on your foreign currency account for which you receive 0.50% credit interest. At the same time, however, you are indebted in CHF, for which you pay 6.5% CC interest at a 0% credit interest rate. You will need the EUR in 1 month to settle a goods invoice and therefore do not want to sell them in order to exclude a currency risk. This results in net interest costs of CHF 2,654.17 at an exchange rate of 0.98 EUR/CHF for 1/2 million EUR.
Optimization option: You swap the EUR for CHF for a period of 1 month using a swap (= Anglo-American term for exchange). As the EUR interest rates are higher than the CHF interest rates (prime rates), you receive the following exchange rate offer from your bank: sale EUR/CHF at 0.98 (+CHF 490,000) and repurchase EUR in one month at 0.9750 (-CHF 487,500). Deducting the interest on the EUR (= CHF 203.-), the net result is now a profit of CHF 2'297.- (instead of a loss of 2'654.17) and exactly one month later we receive another 1/2 million EUR!
Various approaches limit the objective of currency and interest rate management to the individual hedging of a certain cash flow in the future in order to exclude negative currency influences. This often eliminates the chance of a price gain. The key question is therefore: Does the risk control us or do we control the risk?
- qualify risk (export / import / financing / profit)
- quantify the risk (e.g. total risk is CHF 10,000)
- manage risk and exploit opportunities (risk potential vs. value at risk)
Only after these steps have been consistently implemented can a decision be made as to which instruments are suitable for hedging. These can be money market, futures, options or other hedges. Please also note the hedge accounting regulations if you use this accounting practice.
Strategy
The basis for all trading should be rational and strategic, at least in the foreign exchange and interest rate markets. For example, we always recommend finding the absolute zero point first. This is the moment when foreign exchange and interest rate risks exceed a critical level. The critical level is the amount that becomes unpleasant for your company. Hedging at this level should be 100% whenever possible and should also cost as little as possible. Anything above this worst-case scenario must be analyzed individually for each company and hedged accordingly. We will be happy to explain to you on request how you can create such a strategy in a sensible, sustainable and viable way.
Legal aspects
In principle, the legislator does not insist on hedging foreign exchange and interest rate risks. However, there is a clear obligation to avoid bankruptcy. As a rule, the board of directors, CEO, CFO or treasurer can be held liable. We will be happy to find out for you whether and which foreign exchange/interest rate risks have what influence on your business activities.
Reasons for hedging or coordinating currency and interest rate risks
Minimize negative risk (note: risk can also be positive, is determined in a stress test)
- Avoid interest costs
- Make sales price calculations more accurate and reliable
- Gain competitive advantages over competitors
- Short, medium and long-term financial planning
- Securing your existence
Read more about this important topic here.