FX Hedging: Reactionary or Insulating?

A common question for corporates that actively hedge currency risk is whether underlying market trends should influence their risk mitigation strategies. This becomes especially relevant during times of prolonged strengthening or weakening in major operating currencies, when risk managers may be facing persistent unfavorable volatility in financial statements and the C-suite may be weighing changes to the strategic direction of the business if those foreign exchange (FX) trends continue.

Consider the recent strength of the U.S. dollar (USD), which has been especially impactful for corporates whose revenues are primarily foreign and expenses are mostly USD, or vice versa. While high inflation numbers last spring created a brief weakening trend, the prospect of a rising interest rate environment in the United States subsequently pushed the dollar index to its highest levels in 18 months. Corporates whose foreign revenues depreciated against the dollar may be concerned about margin erosion, particularly if Fed rate hikes push the dollar even higher. (See Figure 1.)

But should a trend like this cause treasury practitioners to re-evaluate their hedging strategies?

In answering this question, the first thing to do is to determine how the market trend relates to the company’s unique exposure profile. Even during periods of broad-scale USD strength, there may be more nuanced trends playing out between specific currencies. For example, the Canadian dollar (CAD) strengthened against the USD last year, bolstered in part by rising oil prices that make Canada’s crude exports more valuable, and by increased demand for the Canadian currency. Organizations that have primarily USD expenses and primarily CAD revenues may not be particularly concerned about broad dollar strength. It’s important to understand these types of nuances, paying special attention to the currencies with the most material impact on the company’s financials.