This guide is from our content partner, Ebury
It’s crucial for you and your team to define a robust FX strategy for your business. However, in the global currency landscape, where many factors are constantly changing and evolving and, at times, presenting unprecedented challenges, this begs the question: How do we set a robust FX strategy?
What is a budget rate?
A budget reference rate, commonly abbreviated as budget rate, is a reference exchange rate that a company uses to set prices, costs, or benchmark for a campaign or budget period. One goal of FX strategy is to protect this budget rate and fortify cash flow forecasts when transacting internationally.
For example, if you are a UK importer buying your goods from a supplier in EUR and selling your final product in GBP, you will need to know the cost in GBP to calculate the selling price within the UK.
Setting a budget rate is essential for any global business, whether importers or exporters. It enhances financial planning, improves forecasting, provides certainty about the future value of FX exposures, and helps gauge the impact of FX market fluctuations on profit margins.
Common methodologies to calculate a budget rate
There is no straightforward answer or one-size-fits-all approach to implementing a budget rate in your FX or treasury policy. It should be well-thought, considered within the overall FX strategy, driven by company forecasts and data, and tailored to suit your unique needs and financial goals.
If you are an importer, it can be your cost rate plus some buffer to ensure stability.
If you are an exporter, it is the rate you expect to convert your incoming foreign currency exchange to home currency.
Depending on the seasonality, if you want to set stable prices for the year at the start of your annual budget, the budget rate will coincide with your annual ‘campaign’. In this case, protecting the budget rate (with FX hedging) against unpredictable currency rates is akin to protecting the campaign rate.
However, the approach to arriving at this rate changes if you are a business that runs more than one campaign within a budget period. In this case, you will need to protect the budget rate of an individual campaign rather than the annual budget rate.
Different businesses approach this depending on their business situation, including FX flows, historical data, cash flow forecasts, needs, goals, and even risk tolerance levels. It can be:
- an average rate of the previous year prevailing spot rate
- prevailing spot rate plus/minus some pre-decided buffer
- desired target rate
- current forward rate
- average of previous/current hedges bank forecasts
Each year, each business, and each goal demands a unique approach.
Using last year’s budget rate as a benchmark because the exchange rate favoured you in the previous year may not be the best approach. Similarly, using the current spot rate when budgeting may expose you to future fluctuations. Hence, this approach is best suited when you have a short-term outlook.
In a nutshell, depending on your goals, you’ll set a budget rate before the start of the financial year, season, period or order and, accordingly, design an FX strategy.
Questions to consider before setting a budget rate
If you are from the finance or treasury team, here are some of the questions that will help you assess your business circumstances and FX flows before you set up a budget rate:
- What’s your currency exposure?
- How accurately can you forecast your global cash flows?
- What are your profit margins, and how sensitive are they to currency fluctuations?
- If you set your prices, how do you set them?
- What are the payment terms?
- Has your business assessed the risk you are willing to take?
- Have you set a budget rate or prices already? If so, how long is it set for?
Setting a budget rate isn’t easy. But the right approach will help you build a resilient FX strategy, fortify financial stability, monitor your exposure, and optimise your international cash flows.
Read the free e-book to decode the role of a budget rate, its importance, how to set it and what to consider before applying it:
Also Read
- A comprehensive guide to different hedging programs.
- Debunking the top 5 misconceptions about currency hedging
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