There is one way to prepare for a Euro zone meltdown. If you do business overseas, it's time to consider hedging.
Expanding internationally can be a great way to grow your business. But unless you've been living under a rock, you know that the debt crisis in the euro zone threatens not only "economic destruction," but "possibly a global depression," according to John Normand, J.P. Morgan's global head of foreign-exchange strategy. This week, Norman advised all companies that deal with the euro to start hedging currency.
Currency hedging isn't just for big companies. According to the U.S. Department of Commerce, small and medium-sized businesses account for 97.6 percent of all U.S. exporters and 97.1 percent of identified importers. Experts are advising small businesses that import or export to the European Union to begin hedging (or consider it) now.
After all, if currency fluctuations could jeopardize your company's cash flow, margins, or profitability, it'll be well worth your time.
"It's fairly critical that small businesses [hedge]," says Karl Schamotta, a senior market strategist for Western Union Business Solutions. "The important thing to think about here is that business owners in a dangerous environment need to focus on running their businesses. They don't need to be focused on worrying about the financial end of things. The currency volatility we're seeing is really taking that focus off and materially damaging the bottom line. [Hedging] takes the risk off the table. It allows the business to really budget around the funds that they're receiving or paying."
Entrepreneurs agree that hedging is something that's been on their mind lately. Johnnie Stoker, president and CEO of K2 Energy Solutions, a Henderson, Nevada-based company that makes and sells rechargeable battery systems for electric vehicles around the world, says that even though his company is not hedging right now, they're looking into it. "The cost of setting it up and managing it compared to euro revenue is too high to be worth it for now," he says. "As we keep growing euro revenue, we will probably start a strategy."
Kevin MacDonald, CEO of Black Mountain Systems, a software developer in San Diego that earned $4.4 million in 2010, says that the business isn't hedging at the moment, but "if we were larger and more penetrated [in the EU], we would probably be very concerned."
Schamotta, the market strategist, says that he's seen an "explosion of interest over the last four months" in hedging and in risk management strategies. He expects this trend to continue.
"The euro is triggering volatility throughout the world," he says. "There's a cascading effect that's happening. Many businesses have a set exposure to the euro, and that can materially damage them. But they're able to offset that risk by protecting themselves in other areas of the world as well. You're seeing a more cautious environment in general."
Paul Stafford, the director of Currency Risk Management, LLC, based in Missoula, Montana, agrees that even small companies—those that earn between two and three million dollars in foreign revenue—are finding currency hedging as an increasingly important part of their business plan.
"It's very worthwhile for small businesses because they generally don't have the capital or staying power to absorb larger losses that might occasionally happen with foreign exchange," he says.
Some U.S. companies hedge currencies by doing international business in dollars, but experts say this shouldn't be your sole strategy.
Forward contracts, the most common, and in many cases—practical—form of hedging, is a contractual obligation to buy from, or sell currency from a bank at a predetermined exchange rate. It's worth noting that this protects your company from adverse currency moves, it also prevents your company from cashing in on profit from any favorable moves as well.
Forward prices are determined by an adjustment to the exchange rate made to spot (the current rate), and based on the difference between interest rates between the two currencies. In other words, between the euro and the dollar.
"The brilliant thing right now," says Schamotta, "is that we're in an environement where interest rates are near zero, and so the cost effectiveness is incredible."
So, what do you need to know to start hedging now? It's simpler than you may think.
Stafford lays out the three essential step to setting up your hedging strategy.
Step 1: Find a bank that provides the hedging tools you need.
Step 2: Figure out what kind of exposure you have. (If a significant percentage of your revenue comes from the euro, you're highly exposed to volatility.)
Step 3: Enlist someone—an expert or consultant in this area—that can offer unbiased information.
Stafford, of Currency Management, says the third step is perhaps the most important part.
"A misquote of an interbank rate can double your hedge costs," Stafford says. "And any sort of disagreement in implied volatility can double your options premiums. It's essential to have some sort of a third party that has access to interbank pricing, who can help you negotiate terms with the bank."
There's another reason to consider hedging, too: It may help you beat out your competitors. When companies are able to take their exposure off the books and protect themselves against it, it can be a big boon to their efforts.
"It's a huge competitive advantage for companies because many small businesses are just not that familiar with protecting themselves in this way," Karl Schamotta says. "Those that do manage their exposure properly are improving their competitive positions."
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