Foreign Exchange Hedging
For companies that transact globally, which these days is the majority of companies, foreign exchange (FX) exposure is an essential part of the risk management process. You can have all of your physical contracts perfectly hedged on price, but if you are not considering your FX risk you are leaving a huge component of profitability up in the air.
Most commodity companies keep their books in USD - the LME and CME both settle in USD, it is by far the most widely used currency in our industry. However, unless you are a purely domestic US company, you likely have to deal with counterparties that want to do business in a currency other than USD. Whether that’s the Euro, British Pound, Canadian Dollar, Swiss Franc, Australian Dollar, Japanese Yen, or any other of the many global currencies. Doing business in a foreign currency creates exposures that left unchecked have the potential to cause substantial losses.
Let’s take an example of an aluminum trade where a company that reports financials in USD, is buying from a European aluminum producer and the contract will be paid for in Euros. The trader has purchased 1,000mt of aluminum that has priced on the LME official cash settlement price at $2,300/mt (this particular producer doesn’t hedge and is very annoyed they didn’t price 3 weeks ago at $2,500/mt, but that’s a different story!). In addition to the physical price for the aluminum, a premium of $340/mt was agreed. The companies have fixed the FX rate to convert the contract from USD to EUR at 1.07. This means that the producer is expecting to receive a payment of:
1,000 * ($2,500 + $340) = $2,840,000 / 1.07 = EUR 2,654,205.61
To correctly hedge the Euros for this purchase, at the same time as agreeing the FX rate with the producer the buyer should have sold $2,840,000 at a rate of 1.07 and bought Euros. They would have received exactly EUR 2,654,205.61 on this hedge. They would then use these funds to pay the supplier on the due date.
If, however, the buyer neglected to correctly hedge their FX exposure they would then be exposed to any fluctuations in FX rate between the time of pricing and the time of payment, which in some cases could be weeks or even months depending on the payment terms. Let’s say that in between fixing the FX rate and paying the supplier, the EUR/USD rate went from 1.07 to 1.10. This is only a 2.8% move in FX rate, and given the volatility in these markets this would not be uncommon. When the buyer went to pay the supplier, they would still need to sell USD and buy Euros because that is what the supplier is expecting to be paid in. However, because of the change in FX rate, that same EUR 2,654,205.61 they need to buy is going to cost them $2,919,626.17 (EUR 2,654,205.61 * 1.10) - an additional cost of $79,626.17 vs. what it would have cost them in USD had they hedged correctly. This is a direct hit to their PnL on this deal of $79.6/mt.
An advantage of FX hedging over commodity hedging is that you really can achieve a perfect hedge down to the cent if you so wish because there are no set contract minimum sizes for FX hedging. This is an important factor when it comes to finalizations, which will be part of a separate post next week for month-end.
FX risks are equally important when considering payments outside of the metal itself. If you are making service invoice payments (logistics, warehousing, handling fees, etc.) you must take into account any FX rates on those services. Let’s say a trader is calculating the potential P&L of a 1000mt zinc deal and the logistics and storage is quoted to them in GBP. At the time all of the quotes give the trader an expected P&L of $60/mt. However, included in those calculations are logistics costs of GBP 100,000. At the time GBP/USD was quoted at 1.20. This trader didn’t do any forward hedging and paid the service invoices whenever the service providers sent them. At the time of payment the GBP/USD rate had jumped up to 1.30, so instead of costing $120,000, they cost $130,000, an additional $10k in unexpected costs, reducing the P&L from $60/mt to $50/mt, or a reduction of 16.66%. A move from 1.20 to 1.30 is significant and would usually take time to occur, but physical deals are often calculated and booked on a long-term basis, allowing plenty of time for extreme moves in FX rates.
FX risk doesn’t just pertain to metals companies, it doesn’t matter what line of business you are in, if you transact with companies in a currency other than your own, then you have an FX exposure that you can (and probably should) be mitigating. You would be shocked at some of the companies (think Fortune 500) that either don’t correctly hedge, or don’t hedge their FX exposures at all.
