Any business that trades foreign currencies can be affected by changes in exchange rates.
Where a business is expecting to either receive money in a foreign currency or make a payment in one at a future date, a change in the exchange rate in the intervening period could have an effect. It could mean that they will either receive less than they expected or have to pay out more. The risk of this happening is known as currency risk and when profits are reduced or higher costs are incurred as a result, this is known as currency loss.
This is where FX hedging comes in. FX hedging is what businesses do to reduce the risk of exchange rate changes having a negative impact on them.
Many people find FX hedging to be a complicated and inaccessible subject. However, it’s not actually that complicated, and getting to grips with what a company can do to reduce their currency risk isn’t too difficult. If a business hedges its FX exposure, all this means is that they have adopted a method that reduces or eliminates the risk they face from exchange rate changes.
There are a number of ways that a business can hedge its FX exposure. One of the most widely used methods is through a forward trade and this article will explain what forwards trades are and how they work. Forward trades are simple contractual agreements that a business can make with a third party that allow them to fix an exchange rate for a future point.
Before explaining how a forward trade works, it’s helpful to give an example of how a business that trades in a foreign currency can be affected by changes in the exchange rate. Later on, we can use the same example to show how a forward trade would help the same company to prevent itself from suffering a loss.
A UK-based brewery that has expanded into the US market may take an order for $100,000 worth of its product from a US-based buyer. If the exchange rate at the time the sale is agreed is 0.745 USD/GBP this is equal to £74,500. The company may agree to the sale and send the goods to the buyer, expecting to receive $100,000 from the buyer which will convert into £74,500 of their domestic currency.
However, the buyer may not have to make the payment immediately. They may have a period of, say, three months before they have to make the payment. The amount of time that can elapse varies from deal to deal, but three months is a good example. This is where things become risky. If the US dollar weakens in the meantime, then when the company receives their payment in dollars this will convert to less money in their domestic currency (the British pound) than they expected.
If, for example, when the payment is made the exchange rate is 0.730, this will convert to £73,000 and the company will receive £1,500 less than it anticipated.
Forward trades are used to eliminate the risk of this happening. What happens when a company hedges their FX exposure with a forward trade, is that they enter into an agreement with a third party. Traditionally, these agreements have been provided by either brokers or banks and many companies still use brokers and banks to make these agreements. Bound is not a bank or a broker but is a company that provides the same agreement.
Under a forward trade agreement, a company will agree to exchange an amount of currency at a set rate at a future date with the third party. What this means is that when the company receives their future payment in the foreign currency, they will be able to exchange it back into their domestic currency through the third party at the rate agreed to in the forward trade. Even if exchange rates have changed in the real world, they will be able to exchange their money at the rate set in the forward trade agreement.
Going back to the brewery, when they received their order for $100,000 of their product from the US, they could approach Bound to create a forward trade. Under the forward trade, Bound may agree to exchange $100,000 at a rate of 0.745 USD/GBP in three months’ time. This exchange rate is locked and both parties will agree to settle the deal by a particular date.
Even if the dollar weakens, when the company receives their payment of $100,000 from the buyer in the US, they can take this payment to Bound who will convert it into British pounds at the original rate. So, if the buyer pays three months after the sale is agreed and the exchange rate at that time has changed to 0.730 USD/GBP, this will not matter to them. Bound has already agreed to exchange this payment back into British pounds at a rate of 0.745 USD/GBP.
As a result, no loss is incurred from exchange rate changes and they receive £74,500, as they originally expected. Without the forward trade, the company would be forced to exchange the money through the usual channels and the change in the exchange rate would cause them to lose money.
Importers can use forward trades and it is just the same thing happening in reverse. Using our example again, if the company was importing beer from the US, instead of agreeing to swap dollars into pounds at a future date, they would agree to swap pounds into dollars instead.
With a forward trade, a company can agree to buy from a foreign currency at a future date and fix what exchange rate is available to them on that date.
Forward trades are a commonly used FX hedging strategy and many importers and exporters from the UK and all over the world hedge their trades with forward trade contracts.
The reason they are popular is that they are simple and because they allow complete predictability in cash flow between currency zones. Any business which can accurately forecast its income or expenditure in a foreign currency can simply take a matching forward trade that fixes the exchange rate on what they will receive or payout.
Cash flow clarity is what most businesses look for when they are trading in foreign currencies. Unpredictability is usually the biggest problem, as it makes planning future business operations more difficult. Forward contracts remove the unpredictability and allow businesses to trade in foreign currencies with the same level of certainty as they would have traded in their own currency.
Two other commonly used FX hedging trades are spot trades and options trades. Again, these are ways of exchanging currency that has traditionally been done through a broker or a bank. Bound is also able to offer spot and options trades on their platform.
Options trades are an interesting alternative to forward trades and are another way to hedge an FX transaction. While they are different to forward trades, they can be thought of as an extension on a forward trade.
Put simply, with an options trade you take a forward trade but are not committed to actually exchanging money with the provider of the trade (the bank, broker or Bound). Whereas with a forward trade you are committed to exchanging the amount of currency you agree to with the provider, with an options trade you have the choice of backing out.
What this means is that a company can hedge an FX transaction that it expects to make with an options trade. The option trade will give companies the right to exchange money at a minimum rate at a set point in the future if they want to.
If the transaction the business is expecting to make doesn’t go ahead, then they can back out of the options trade and will not be committed to exchanging money. There is a cost to taking out an option trade, but when they have used the benefits of taking out an option trade outweigh the risk of it not being needed at all.
If the transaction does go ahead, the company can then pay attention to the exchange rate. If, after the transaction is complete and the company receives its payment in a foreign currency, the exchange rate has moved unfavourably, the company can execute the option trade. The option trade will allow them to exchange the foreign currency back into their own currency at the minimum rate set in the options trade agreement. This will prevent them from losing money due to the unfavourable exchange rate movements.
Alternatively, and this is where option trades can be useful if the transaction goes ahead and the exchange rate moves favourably, the company can back out of the options trade and exchange money at the spot exchange rate (the normal current exchange rate). This allows them to profit from the favourable change in exchange rates.
Spot trades are not really an FX hedging tool. Spot trades are normally foreign exchange transactions that are done at the current or ‘spot’ exchange rate. In the context of an options trade, a spot trade can be thought of as an FX hedging tool as they allow an alternative to trading at the rate given in an option trade agreement. However, they are effectively just run-of-the-mill foreign exchange deals that are done at the current market rate.
Bound provide spot trades on their platform and use the interbank rate to ensure that their customers are getting the best deal available. Spot trades done through Bound can be completed in a matter of minutes and are done with complete transparency.
Forward trades are a commonly used FX hedging strategy. Hopefully, having read this article you understand how simple they actually are. Also, hopefully, you understand how a business could use one to fix exchange rates when trading in foreign currencies. Forward contracts are simple to arrange and allow businesses to operate with complete clarity about what their revenue and costs will be when trading in foreign currencies.