A budget rate is a reference exchange rate, set by a company with international exposure, applied to foreign exchange transactions undertaken by the business. Often, hedging strategies are taken out to ensure the budget rate is protected.
Setting a budget rate is pivotal for any business transacting cross-border, no matter whether an importer or an exporter. Budget rates play an important role in the financial planning process – giving companies improved forecasting ability, and enabling increased certainty over the future value of FX exposures. <br> <br> There are further benefits. Overseas business performance can be more effectively measured via the use of budget rates, allowing a company to see whether increased revenues are owing to organic improvement in an international business unit, or whether they are simply due to a move in the FX market. This not only assists with measuring overall business performance, but also in determining individual and team performance metrics. <br> <br> Three considerations should be borne in mind when deciding on a budget rate; its attainability, stability, and objectivity.
Setting a budget rate that is unattainable is pointless; a company doing so may as well not have a budget rate at all. A business’ risk management policy should seek to obtain the budget rate, rather than to outperform the market – though this can and does depend on the risk tolerance of the corporation involved.
Stability is also an important consideration. Typically, businesses seek to minimise the difference between budget rates from one accounting period to the next. This provides increased consistency for accounting purposes, and further reduces the volatility typically associated with cross-border transactions.
Perhaps, the most important consideration, however, is objectivity. Corporates should seek input from all major stakeholders within the business, as well as external unbiased experts, when selecting a budget rate, in order to produce an impartial estimate of the forecasted rate. A budget rate should be where all stakeholders think the market will go, rather than where they wish it would go.
Implementing a budget rate
Implementing a budget rate is just as important as setting one, though trade-offs are inevitable. Locking in a hedge (via forward contracts) at the start of an accounting period eliminates all uncertainty. Though it can introduce greater period-to-period variation, as well as removing the possibility to outperform the market. <br> <br> Such outperformance can typically only be achieved by taking on risk, either by averaging into a hedge, remaining under-hedged, or via the use of FX options and other structured products. Flexibility of budget rates – i.e., how they can be changed in response to prevailing market conditions – as well as incentives within an organisation to achieve budget rates, are also important considerations. <br> <br> In summary, the setting of a budget rate will vary significantly depending on a business’ individual risk appetite, and their position in the corporate lifecycle. Speaking to an FX specialist helps ensure that a budget rate hits all of the aforementioned criteria, as well as enabling effective implementation of appropriate strategies.
In Practice: limiting exposure to Volatile FX markets
The CEO of an international plant manufacturing recently highlighted how Caxton helped them navigate the currency markets and set a plan in place; <br> <br> “Caxton limits our exposure to changes in the market. So, we’re able to sell internationally as well as actively manage our foreign exchange rate.” <br> <br> “Caxton devised a plan to guarantee our exchange rates, despite the fact that Swedish Krona can be more difficult to plan for the future. The team’s experience leaves me to focus on daily operations. And if I have any queries, our dedicated account manager is always on had to help me, no matter what.”
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If you're looking for more information on managing FX risk then check out our Managing Risk Hub or check out our FX glossary for frequently used terms.
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