Do you use options as a part of your foreign currency risk management program? When I started out in FX, options were left to the largest organisations. These days they are increasingly promoted as the go-to risk management product. Have you ever considered why FX options are promoted so heavily by the banks and money service businesses? If you think it is because they are the most appropriate instrument for your business, you might want to read on.
Over the last 10 years there has been a proliferation of options offered in the FX market, particularly in the SME space. Options are being offered more and more to less sophisticated (from financial engineering point of view) customers. Is this because there is more optionality in the cash flows of customers? Absolutely not. Do FX providers make more revenue from options than they do from more vanilla alternatives? Absolutely. When your customer has no reference for the pricing of what you are offering, the price often ends up being “what I think I can get away with.”
At large scale a risk management program costs significant sums and manages company-critical risks – so learning from the top end of town can be instructive in your approach to implementing an appropriate program. The primary aim of risk management is to protect your company’s money. This is why large companies pay tens of thousands of dollars for data and information. It is also why I hear bankers say that there is no longer any money to be made in institutional FX. The only thing that is different between institutional-level clients and smaller clients is access to the pricing information and tools. Without information, you are swinging in the dark. Lined up against friendly people who are highly incentivised to maximise revenue for their organisations. Smooth sales techniques, wrapped in sophisticated market talk. Remember, this is a zero-sum game – every point in margin you give away is a point of revenue for your dealer.
If you don’t know what is being earned by the bank on the FX hedging products you are buying, then it is definitely more than you think. So how can you approach your risk management activities to ensure you get the best value for the protection of your company’s exposures?
#1: Keep it simple
You should resist the temptation to add complexity and expense into your risk management program because the return you will likely see on this complexity is negative. Always keep in mind that the reason you are executing a risk management program is to support your business. What does the business actually need? Continuing exposure to the FX rate is probably not one of those things. In fact, where you can avoid execution of hedges, you should. Offsetting payments coming in and out in a foreign currency is not only the most efficient form of hedging, but also the most cost effective.
#2: Analyse and deconstruct your exposures
If there is no variability in the size of the cash flows you are hedging, why do you need variability in the amount of cover you have? If you do have variability in the size of your cash flows, you should break them into core non-variable and non-core variable components so that you minimise the comparatively expensive option component of the program. Use FX forwards for the core part of your program and only use options where you have a genuine need for variability in the amount you have hedged.
#3: Know what you are paying in margin
When it comes to managing FX risk, I have a firm belief that if you can’t price something, you shouldn’t be doing it. Why? Because it is extremely expensive to execute in the dark. Which is why options are so attractive – to vendors. Pricing is complex and opaque, and consequently selling options is profitable. Clearly, the only way to have an intelligent conversation about how much revenue you are paying to your dealer is to know how much that revenue it actually is. You can’t negotiate in the dark, and your dealer is never going to put their hand up to reduce their own revenue. There are a number of other reasons knowing how much you are paying in margin can help, we’ll cover that in a future article.
Historically, access to FX market pricing and information has been the domain of large organisations as it has been prohibitively expensive. This is why we built FairDealFX – to bring some balance to the conversation SME’s have with their FX providers. The result will be to lower the costs of your hedging program – guaranteed or it’s free!
If you’re ready to step out of the dark and into the light, sign up here for your free trial.