Pricing and FX Hedging: How to Use Pricing Measures to Respond to Currency Fluctuations

January 20, 2021

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Currency fluctuations continue to create major challenges for many companies in their foreign markets. We worked with Dr. Siegfried Jaschinski and Gerhard Jänsch, financial experts at Augur Capital, to develop a new approach for curbing the impact of these volatile developments on revenue and earnings: effective price and currency management.

Business in foreign markets and the resulting revenue are more important than ever for companies in the current global recession. Global crises such as the financial crisis of 2008 and 2009 and the current COVID-19 crisis lead to significant fluctuations in exchange rates. For example, from 2008 to 2010, the euro-dollar exchange rate fluctuated by at least 30 percent, and in 2020, the fluctuations in China, Japan, and the US exceeded 10 percent at the expense of a strong euro. In the latter scenario, an export-oriented company with production based in the euro would need to implement price increases of up to 10 percent in order to avoid a drop in earnings with unchanged sales.

Counter the effects of currency fluctuations effectively in five steps

Our newly developed approach involves placing the price and sales situations of the respective foreign market in the foreground. To minimize the effect of currency fluctuations, companies should carefully analyze the impact on the respective competitive situation and implement price measures before resorting to currency hedging transactions. We suggest taking the following steps:

  1. Determine currency scenarios based on the most important influencing factors
  2. Establish transparency on how these factors impact earnings and revenue
  3. Analyze the local competitive situation and price sensitivity of the product portfolio
  4. Adjust the local price corridor based on the recommended price, escalation price, and price limit
  5. Offset the loss in earnings with targeted hedging strategies

Step 1: Determine the trend of currency fluctuations

Companies need more than short-term exchange rate forecasts that banks make to identify trends in currency fluctuations. Our newly developed FX scenario program provides comprehensive predictions by incorporating the most important influencing factors, such as differences in the current account, economic developments, and interest rates. Companies can use their growth expectations in the foreign currency market, in addition to financial market information, to estimate the input factors. Using the results of a regression analysis, companies can then define the weight of the influencing factors to determine the trend in currency development and generate a base scenario. This process can be repeated with different expectations to map additional currency scenarios.

Step 2: Simulate the effects and establish transparency

Companies can also use our FX scenario program to establish transparency on how currency development is expected to impact their earnings and revenue. They first need to enter the open currency positions resulting from sales and the base scenario. The extent of the impact on the income statement determines the magnitude of the price and hedging measures, revealing how currency fluctuations in foreign markets will affect the company’s overall situation.

Step 3: Analyze the competitive situation and product portfolio

Before resorting to hedging measures, companies should examine how changes in exchange rates affect the competitive situation. Competitors domiciled in foreign markets have no reason to adjust prices in response to changes in exchange rates and can even use these fluctuations to their advantage. Companies need to analyze their product portfolio in detail to determine the extent to which price increases or decreases enforced by the competition are necessary, keeping in mind the degree of differentiation (e.g. unique selling proposition, “fast movers” [price sensitive], “slower movers” [price insensitive]) and the product lifecycle.

Step 4: Adjust the price corridor

Sales teams usually manage currency fluctuations by annually adjusting local list prices for local market situations and deal-specific, targeted street prices for individual customers. With our newly developed pricing tool PeerPricer, teams can take into account dynamic factors, such as currency development, in addition to situational factors, such as product mix, customer type, and order quantity. The tool then generates specific price corridors, consisting of a recommended price, escalation price, and price limit, for each deal situation and defined currency development scenario.

Step 5: Offset lost earnings

By implementing these targeted price measures, companies lower currency-related earnings risk and, in doing so, reduce the open currency position for the simulation program. The effect on the income statement (P&L) is simulated for the remaining risk, and in a second step, the program generates suggestions for hedging transactions. Market data can be used in web-based simulations (with minimal time lag) to determine futures and option business for closing the earnings gap. The simulation program enables companies to merge the open and hedged currency positions of all foreign markets with different currencies and is recommended for management reporting.

Tap significant potential by linking price and currency management

By regularly implementing these five steps throughout the year, companies can successfully manage strong currency fluctuations. We recommend firms start by piloting one foreign market (e.g. the US market for companies from Euro-area and vice versa). Connecting price and currency management can generate considerable P&L-relevant optimization potential. Just a 10-percent currency fluctuation can impact revenue by 10 percent. Even if companies are only able to implement one aspect of this plan, integrating price and currency management always pays off.