Currency hedging, or FX hedging as it’s otherwise known, refers to various ways in which businesses protect themselves from fluctuations in the exchange rate.
Any company which either buys or sells in a foreign currency during the course of business can be at risk from changes in the exchange rate. If they don’t do anything to control this risk, an adverse move can cause them to lose money. To save themselves from losing money, many businesses choose to hedge their FX risk.
This article will quickly jump through all of the most common ways in which businesses all over the world protect themselves against currency fluctuations by hedging FX risk.
Hedging FX risk is all about finding an alternative for future currency exchange to waiting and then exchanging currencies at the spot rate. The spot rate is the current market exchange rate which is immediately available at any point in time.
Strictly speaking, when you hedge your bets you give yourself two options. While this is the case, not all methods of hedging FX risk actually give a business two choices. The term FX hedging is just used in the industry to refer to all the ways in which businesses protect themselves from FX risk. Some methods just give a business one alternative to exchanging currencies through the usual channels. However, this will be far safer than it would otherwise be.
Forward trades are very widely used and are a simple way of completely removing the risk that a company that trades in foreign currencies faces from fluctuations in the exchange rate.
Before explaining how they work, it’s helpful to quickly run through the most common form of currency risk, which is known as transaction risk. This is the risk that arises when there is a gap in time between a transaction in a foreign currency being agreed to and is taking place. At this time, the exchange rate can change unfavourably. Nonetheless, the company will be committed to the transaction. When they complete currency exchanges in order to complete the transaction, if it’s a sale then profits could be reduced and if it’s a purchase it could cost more than expected.
With a forward trade, the company would be offered a contract that fixes the exchange rate for the future. Traditionally these contracts were given by banks and currency brokers, although companies like Bound are able to provide them as well.
The company will be able to agree to exchange a certain amount of one currency for another on or before a certain date at a fixed rate. The fact that the rate is fixed means that they can commit to completing a transaction in a foreign currency with certainty about what exchange rate they will receive when the time comes. As a result, profits or costs are set in stone.
Forward contracts can be used in a variety of ways, with some businesses using them infrequently and only for large transactions. For other businesses, they may be used very frequently to hedge a large number of transactions.
With forward contracts, there is a commitment to completing the exchange of currencies that has been agreed to. As such, they cannot really be used to hedge bets. There is only one course of action with a forward trade and that is to exchange currencies with the forward trade. This is where option trades come in.
Option trades are a way of truly hedging your bets. With an option trade, you pay a premium to have the right to exchange a certain amount of one currency for another at a fixed rate on or before a certain date. Similar to a forward trade. However, there is no commitment to completing the exchange of currencies.
This means that they can be used to provide a safety net if necessary, but they can also be disregarded in situations where this would be beneficial. For example, if a transaction in a foreign currency is agreed to and is set to take place at a future date, a company can take out an option trade. If the exchange rate changes unfavourably, they have the safety of exchanging currencies at the rate set in the option trade. If it moves favourably, they can disregard the option trade and exchange currencies through the usual channels and benefit from doing so.
Limit orders are a relatively well-known thing and can be used to ensure that a business gets the exchange rate that it wants to. While they can be used to hedge FX risk, they are usually only really useful to businesses that are not committed to deadlines. They are a favourite for importers who are not committed to deadlines when importing from overseas.
Limit orders are usually automatic. A business will instruct usually a currency broker or bank to exchange currencies once exchange rates move to a certain point. This will be the ideal rate at which the business would like to exchange currencies. A corresponding transaction can then take place in the relevant foreign currency using the funds which have become available.
Stop loss orders are similar to limit orders, except that they are used to set a worst-case scenario under which an exchange of currencies will take place. With a stop loss, everything worse than the worst-case scenario will be avoided.
Again, a business using a stop loss will usually do so with a currency broker or a bank. They will instruct them to exchange currencies as soon as exchange rates drop below a certain point. By doing so they will have avoided having to exchange currencies at a worse rate.
This can be used in a variety of ways. An example of how it can be used is for payment for a purchase made in a foreign currency. A business that has agreed to make a payment for one can set a stop loss order with their payment provider. They can then wait and see if the exchange rate will move favourably before they make payment.
If exchange rates do move favourably, they can make the payment and benefit from doing so. However, without the stop loss, they may be vulnerable to unfavourable exchange rate movements. The stop loss will be triggered if exchange rates move to a certain point and the company will accept exchanging currencies at the worst-case scenario they have set.
As you can see, all of the FX hedging methods mentioned so far require a business to use the services of an outside organisation. Internal hedges, on the other hand, are things that a business can do without seeking external help.
With risk sharing, two companies from countries that have different currencies will agree to split any differences which arise as a result of exchange rate fluctuations while they are doing business with one another.
With matching, which is also known as natural hedging, a business that both receives and makes payment in a particular foreign currency will match them together to avoid having to exchange currencies. For example, rather than exchanging currencies, incoming payments will go directly towards the outgoing payments that the business needs to make in the foreign currency.
With leading and lagging a business will simply look to complete transactions at a time when the exchange rate is favourable to them. This requires management and is risky as there is no guarantee that exchange rates will move favourably.
A business can attempt to vary its price on one day to match what it expects to receive in the future with changes to the exchange rate taken into account. Just like with leading and lagging, this is risky as it is difficult to predict how exchange rates will vary in the future.
A business can simply invoice overseas customers in its domestic currency. While this completely removes the risk for the company itself, it passes it all on to its customers. This often results in a loss of sales.
Money market hedges are a solution to FX risk whereby a company either borrows or lends money to the money markets in anticipation of a transaction taking place in a foreign currency at a future date. By completing this action in advance of the actual transaction taking place, any changes to the exchange rate which take place do not have an effect.
The company can agree to the transaction and when the time comes to complete it, they can access their money market hedge. If it is a purchase, money lent to the money markets is used to make the purchase. If it is a sale, the proceeds of the sale are used to satisfy a loan taken from the money markets.
Futures contracts are similar to forward trades and the two are sometimes confused by those who are new to FX hedging. While they are similar, they are actually quite different.
With a futures contract, you can exchange a certain amount of money at a fixed rate on or before a future date. Just like with a forward trade. However, they are sold on an exchange with standardised amounts for exchange with standardised settlement dates. As such, they are much less adaptable than forward trades and for many businesses are an inappropriate choice.
The customisable nature of forward trades makes them much easier to use and futures contracts are often only used by larger businesses to cover large transactions.