When it’s OK to be naked

By being naked, I am, of course, not referring to a lack of clothing but the term often used to describe a lack of any cover (hedging).

In option trading parlance, being “naked” refers to holding an option that is not secured against an underlying position, being uncovered. It might help to think about it in relation to a physical asset, such as having no insurance cover for your house or car, or making a nudie run at midday down the main street – very risky!

At OzForex, we are constantly educating our business clients about sound risk management practices, which more often than not means having an appropriate level of FX cover in place: whether via a Forward Exchange Contract or an Option.

There are, however, some business models and circumstances whereby having no cover (being naked), is OK or carries less risk.

Two-way flows, same currency

For example, an Australian business may be involved in both import and export and as such have cash flows in two directions for the same currency (i.e. they both receive and pay the same currency). This could be because they source raw materials from overseas in US dollars and sell their finished products overseas for US dollar payments.

In this instance, there is what is called a “natural hedge” in place that removes the need to convert funds twice. It is common for businesses like these to hold foreign currency bank accounts so they can receive and hold foreign currency balances – they then use some of these funds to pay suppliers at some point.

Note that it is, however, unlikely that the two cash flows match exactly because – one would hope anyway – the company is receiving more than it is paying. Hence there is still some currency conversion to be had along the way. There are some risks involved for businesses in this position if they don’t hedge as there will be timing mismatches that can leave them exposed to some FX risks, but it is less than businesses with cash flows in the one direction.

Short payment cycles, high margins

Secondly, if a business has short dated payment cycles and operates in a high margin environment (lucky them!) then there may be less FX risk. For example, if the business has seven days to pay USD from the time the deal is originated, and can build an FX margin of 10% into their pricing, then there is less urgency for them to take out some hedging.

As a result, most of these types of businesses tend to stay naked, which can see them deliver some extra margin, or lose some, but it is somewhat limited given the short timeframe. We find some businesses like this may have hedged in the past but now take the approach that the ups and downs smooth themselves out over time.

Swinging both ways

Finally, there are those that swing both ways, i.e. move from naked to covered (and vice versa) depending on the trend in the currency. While following the philosophy “the trend is your friend”, some Australian-based importers may have moved from a strict hedging policy in years gone by to a naked (uncovered) policy since the Australian dollar has perched itself above parity.

This can work well for a period of time. However, by the time the trend has reversed, and so too their hedging policy, it may be a little late. Some argue that the extra FX margin to be had during the rise will more than offset any increase in cost or compression of FX margins by a lag in changing policy back to being covered.

In summary, it is OK to have no FX cover and be naked sometimes, so long as the business is aware that there are still some risks, continues to review the policy, and takes an appropriate course of action to address this if the impact on the bottom line becomes an issue.

Jim Vrondas is chief currency and payment strategist, Asia-Pacific, at OzForex, Australia’s leading international payments solution provider.