For those who are new to FX hedging, understanding how it works can be confusing. There's a lot of terms and strategies thrown around. It can be overwhelming learning what all those are and putting two and two together. Because of how complicated it can look (it isn't), most people turn their heads and decide, "maybe another day." And then, another day never comes.
In this article, we will show you 10+ situational examples of when and how you can do FX hedging. These examples will help you understand the simplicity, importance, and use of FX hedging in real-life situations. So, if you're pretty new to FX hedging or forex in general, you're in the right place. If you're experienced or a pro, these might also help you recognize your mastery of the basics. And translate them in the more complicated situations you face—with a fresher perspective and a better strategised solution. So, quick review...
Otherwise known as currency risk, businesses run into foreign exchange risk when they make foreign currency transactions and rates fluctuate. In simpler terms, if you run a business that exchanges different currencies often, chances are you have currency risk.
Businesses like importers and exporters can suffer significant losses when exchange rates move against their favour. Losses can amount from a couple of hundred quid to tens and thousands of pounds.
Changes in exchange rates can result in higher costs for importers. At a disadvantage, they'll need more of their own currency to make a foreign currency sale. Meanwhile, for exporters, reduce or complete loss of profits can happen. This happens when earnings in foreign currencies convert less in the company's domestic currency.
Transaction risks are a common form of foreign exchange risk. This happens during a time gap between when both parties agree on a sale and when it actually happens.
Like every business is unique, its operations will also need unique payment arrangements. Time and time again, the problem stays the same. If exchange rates don't move favourably during this period, money in varying sums can get lost.
To overcome this risk, smart businesses, mostly huge ones, use FX hedging. Hedging risks related to exposure to exchange rate volatility gives a company a measure of certainty of how much payments can be in the future.
Two common ways of FX hedging are forward trades and option trades. While they are simple, widespread use of jargon and lack of simpler info about the markets tend to scare people away from it. We want to make these useful methods of FX risk hedging simpler to understand. Starting off with some examples of both how forward and option trades work:
With a forward trade, a business locks in an exchange rate on a future date for international transactions. Usually prepared through a third-party provider like Bound. The business then makes a contractual obligation to trade currencies on the agreed date.
Forward trades are particularly useful for exporters. They give them a guarantee that exchange rates they've agreed on today will be the same for them in the future. Even prices change then.
Let's take for example a British furniture maker who exports furniture to EU countries. To receive payment, they would need to convert euros to pounds.
As part of its ordinary business, the company may receive an order for €1,000,000 worth of furniture from a buyer in the EU. They may agree to the sale and receive the payment within six months. By agreeing to the order, they will have exposed themselves to foreign exchange risk.
The exchange rate at the time of sale may be 0.87 EUR/GBP (as it was in February 2021). They expect to receive £870,000 as payment after conversions. Yet, before actually receiving payment exchange rates may change suddenly. Six months later, the exchange rate could be as low as 0.846 GBP. This would mean that the company would receive £846,000, £24,000 less than anticipated.
Situations like these make it favourable to do a forward trade. You definitely can't put off getting paid £24,000 less as a discount. Can't you?
To avoid the risk, the company can approach a foreign exchange provider to take out a forward trade. Traditionally, banks and brokers act as foreign exchange providers. Although Bound is not a bank or a broker, we're foreign exchange providers.
FX providers agree to exchange €1,000,000 into GBP at an agreed 0.87 EUR/GBP. They agree to exchange at a certain rate somewhere within the next six months. The company and FX provider can negotiate on the agreed rate but it would be something close to 0.865 EUR/GBP. Exchange rates are then locked. No longer exposing the company to exchange rate fluctuations.
When a transaction takes place, the business receives a payment of €1,000,000 to convert back into GBP at the set rate of the forward trade. In this example, they receive £865,000 and avoid a potential loss of £19,000.
Importers also use forward trades and it happens reversely but no difference.
Let's go back to the British furniture company but this time it's importing from an EU seller. Under the same conditions, they can take out a forward trade to prevent the purchase costs from increasing all of a sudden.
They can approach the same FX provider after placing an order for €1,000,000 in furniture to take out a forward trade. The forward trade allows them to exchange currencies again at a set rate for a set date. When they're ready to pay, they convert currencies with the forward trade to make the payment. Again, the set rate of the forward trade doesn't change with current exchange rate prices.
With an option trade, a company exposed to FX risks can set exchange rates at a future date just like a forward trade. Their only difference is an option's lack of contractual obligation to go through with the exchange. If the company wishes not, it can choose to opt-out of the option trade.
This makes options pretty useful for speculative situations. Situations where the business expects foreign currency transactions but decides not to go ahead with it. Yet, that's not all they're limited to. Having the choice not to use an option trade gives a business the chance to take advantage of potential cheaper currency rates in the future.
Exchange rates move favourably in the time between the agreed transaction and when it takes place. If this happens, the company can choose not to use the option trade. Then, trade at spot market rates that turn out to be lower than expected.
While there is no contractual obligation to complete an option trade, there is a fee for taking one out. Even if you do not use the option, your paid fees are now—lost. But, the fee is only lost in situations where this is acceptable. When exchange rates move favourably, the company actually benefits more than the actual fee.
Okay, another example, say a US importing company buys goods in US dollars for sale in the UK.
The company may be expecting to place an order for $1,000,000 worth of goods from the US.
Option trades prevent a business from suffering a loss if the placed order and exchange rates move unfavourably. If the order is not placed and the transaction does not go ahead, they are not obliged to go through with it as they would in a forward trade.
The company can hedge the risk posed by exchange rate changes by approaching an option trade provider to take out an option trade.
The option trade provider will agree to exchange a certain amount of British pounds into US dollars before a certain date if the company wishes to do so. For example, our importer could take an option trade to convert £72,500 into $1,000,000 at a rate of 1.38 GBP/USD. This rate would be set and if the company wishes to do so, they can convert currencies at this rate on or before the agreed future date.
The company has now hedged the risk to which it is vulnerable and can choose whether to use the option trade or not.
If the expected purchase of goods does not go ahead, the company does not use the option trade. While the premium loses, there is no commitment to complete the exchange of currencies as there is with a forward trade.
If the purchase does go ahead at the future date. exchange rates have moved unfavourably then the company can use the option trade to exchange currencies. They exchange currencies with the option trade and pay for the order in US dollars. By using the option trade, they will have avoided the higher cost they would have paid for exchanging currencies at the spot rate.
If, for example, the exchange rate has changed to 1.40 GBP/USD, the company will use the option trade to avoid spending more to make the purchase.
If the purchase goes ahead and, when the payment is due, exchange rates have moved advantageously then the company can decide not to use the option trade. They then take a spot rate trade instead and benefit from the favourable change to the exchange rate. For this company that would mean they would make the purchase for less than they anticipated.
If, for example, the exchange rate has changed to 1.36 GBP/USD, the company will not use the option trade. They will disregard it and trade at the spot rate.
Again, exporters can use option trades as effectively as importers and the same thing happens the other way round.
With an option trade, an exporter would be able to protect profits from being reduced or lost on orders in foreign currencies. They are useful for speculative situations, where companies are unsure whether orders will be received or not. On top of this, where sales are made in foreign currencies, they protect profits while also allowing companies to benefit if exchange rates move favourably.