An astounding thing we have encountered while advising companies on forex risk management is that almost no company has allocated a budget for meeting forex hedging costs. Companies may have voluminous FX hedging policies, in hardbound book form, put together by their risk management committees which are duly approved by their Boards. But, when we ask them whether they have approved a Hedging Cost Budget, we are met with uncomprehending stares. "Hedging cost budget? What's that?"

The two main reasons for the non-existence of an explicit hedging cost budget are:

• Most of the hedging is done using Forward Contracts, wherein the hedging cost or forward premium is built into the price. Since it is not paid separately upfront, it does not get recognized as an explicit cost. That does not mean, however, that it is not hedging cost.
• Most companies use the Forward Rate for budgeting their imports/ exports and as such the hedging cost is implicitly added to the raw material cost or product cost. In this manner the cost of the activity of hedging is shifted to the activity of procurement or manufacturing or sales.

Why a Hedging Cost Budget is needed

That most people are doing things this way does not necessarily mean it is the best way to do things. In earlier articles we have explained how Forwards are not forecasts and are therefore not the best way to budget for future forex transactions and that it is better to use explicit currency forecasts for budgets instead.

The benefit of using currency forecasts for budgeting is that you end up focusing more clearly on FX risk. From that emerges the need to manage that risk. And thereby arises the need to hedge as a means of mitigating such risk and from that, again, emerges the need to budget for the cost of hedging.

Have you ever wondered why most companies tend not to use Options as a hedging tool, even though Options are sometimes more effective than Forwards for hedging? It is because there is no budget available for paying the upfront option premium. That is also the reason why many companies who do use Options are attracted towards "zero cost options" and end up losing money in times of excessive volatility. Not having a hedging cost budget also acts as a disincentive for companies to exit unprofitable hedges.

If a company were to sanction a budget for hedging costs, it would be able to pay for Options and it would be able to accept "stop losses" on unprofitable hedges. In total, it would be able to hedge more efficiently.