Any company which conducts business in foreign currencies faces the risk that exchange rate changes could reduce profits or increase costs.
A common example of when this can happen is when there is a time gap between either a sale or purchase in a foreign currency being agreed to and it actually being made. In the time between an agreement being reached and the transaction actually occurring, exchange rates can change for the worse. For exporters, this means that earnings turn out to convert into less domestic currency than expected, and for importers costs in foreign currencies increase.
The risk of a company losing money to exchange rate changes is known as foreign exchange risk or currency risk. FX risk management tools and strategies are just methods that companies can follow or arrangements they can make to stop or reduce the risk of exchange rate changes having a negative impact on them. For a bit more help with jargon, what people are referring to when they talk about FX hedging (if you have heard this term as well) is just the process of a company adopting a method or making an arrangement like one of the ones listed below.
Here are some of the most commonly used FX risk management tools. If your business trades in foreign currencies, it may well be worth looking into whether or not one of the tools listed below could help you to control what you pay out or receive when you’re trading in foreign currencies.
Forward trades are commonly used tools for foreign exchange risk management. With a forward trade, a company that trades in foreign currencies makes an arrangement to fix the exchange rate that it will receive at a future date.
When a company is certain that either an outgoing cost or an incoming payment will be made in a foreign currency in the future, they can approach a forward contract provider to fix the exchange rate they receive when the transaction occurs. Companies that have predictable transactions in foreign currencies find forwards trades particularly useful because trade can be planned and executed with complete certainty about exchange rates.
As a simple example, an importing company that places an order for materials from another country, for which payment will be made before a certain time in the future, can use a forward contract to set for definite how much this order will cost in their domestic currency. When they place the order for the materials, they can approach a forward trade provider to set the exchange rate at the current exchange rate and agree to exchange the money on the day they intend to pay for the materials.
When the time comes to pay, even if exchange rates have changed negatively on the normal exchange markets, they will be able to exchange currencies at the rate set in the forward trade.
Forward trades allow companies that import and export from foreign currency zones to operate with the same level of certainty as if they were trading in their own domestic currency.
Option trades are less commonly used than forward trades but are another widely used tool that can be used to overcome the problem of exchange rate changes. Option trades are another arrangement that a company can use to fix the exchange rate for a future date and can be thought of as an extension on forward trades.
With an option trade, a business that trades in foreign currencies can agree with an option trade provider to fix the exchange rate that it receives at a future date. However, the difference with an option trade is that there is no commitment made to exchange currencies. The company can opt-out of the option trade if it wants.
This brings advantages. One advantage is that they can be used when a company is not sure whether it will need to make a transaction in a foreign currency. They can use an option trade speculatively and if either a sale or a purchase is agreed to in the future when the time comes to complete the transaction, they will be guaranteed to at least receive the exchange rate set in the option trade. If the anticipated transaction does not take place, then they are not committed to the option trade and can back out.
Another big advantage that they bring is that, if the company does find that it needs to exchange currencies to complete a transaction, but exchange rates have moved in a favourable direction, they can back out of the option trade and exchange money at the normal market rate. This is known as taking a spot trade and allows the company to benefit from the positive move in exchange rates, instead of being tied into exchanging money as they would be with a forward trade.
Internal hedging tools are methods that companies can use and arrangements they can make using resources that are available within the business. Forward trades, option trades, and other FX risk management tools require help from third parties. Internal hedging tools are things that a company can do by itself. Here are the most commonly used internal hedging tools.
This is an obvious way to overcome the problem, which exporters can use. Instead of taking the risk of suffering from exchange rate movements, a company can just invoice its customers in its own domestic currency. While this completely removes the risk of exchange rate fluctuation, it passes on the risk to customers and can cause lost sales.
Companies from separate currency zones which trade with one another can agree to split the risk of exchange rate changes. Often two companies will agree to have an equal share of any difference which arises from a change to the exchange rate which takes place between a transaction being agreed to and it is made.
If a company ‘leads’ or ‘lags’ it looks to either make or receive payments at a time which avoids any negative impact from exchange rate changes. A company will look to receive payments in foreign currencies before they weaken against their own. Likewise, they will look to make payments in foreign currencies before they strengthen against their own. This approach does work for some, but it requires management and can be risky as exchange rate changes are hard to predict.
Also known as natural hedging, matching happens when a business both receives and makes payments in one particular foreign currency. A company can use payments it receives in a foreign currency to make any outgoing payments it needs to make in the same foreign currency. This avoids the need to exchange currency, except where there is a surplus amount left over after transactions are completed.
Outside of forward trades, option trades, and internal hedging methods, two other quite commonly used FX hedging tools are money market hedges and futures contracts.
Money market hedges are another foreign exchange risk management tool that requires a company to seek outside help.
While the process of carrying out a money market hedge is actually quite complicated, the basic idea behind them is fairly simple. A company can use the money markets, which are markets for trading in short-term financial instruments, to either lend or borrow money in a foreign currency. This can be done in anticipation of the company either receiving or making a payment as part of its normal business in that foreign currency.
By borrowing or lending in the foreign currency through the money markets, the company will be able to fix the exchange rate that it receives for the foreign currency payment or receipt at the current exchange rate (or whenever the money market hedge is done). Usually, when the company expects that a transaction in a foreign currency will occur in the future, it carries out a money market hedge at the current exchange rate.
When the transaction does eventually take place, if it is a payment, the funds which have been stored in the money market hedge can be used to make the payment. If it is a receipt of money, the funds received can be used to satisfy what was borrowed through the money market hedge.
Futures contracts are similar to forward contracts, but rather than being agreements that can be individually tailored to a company to hedge a specific transaction, currency futures are standardised products that are sold on an exchange. Futures contracts are generally standardised in terms of the amount that can be exchanged with one and when the contract expires. For example, euro futures contracts come at amounts of €125,000 with quarterly expiration dates.
The agreement that a company can rely on is the same with a futures contract as it is with a forward contract. After buying a futures contract, a company will be able to exchange money in the future at the rate that is set when the futures contract is bought.
For example, if a company wished to make a purchase in a foreign currency in three months’ time, they could buy a futures contract at the current exchange rate which would expire in three months’ time. When the time came to make the payment, they could exchange their domestic currency into the foreign currency using the futures contract. If the current exchange rate had changed negatively in the meantime, they would still be able to exchange currencies at the rate set in the futures contract.
One way that futures contracts often differ to forward contracts is that there is a price for obtaining one. Often, forward contracts do not come with an initial cost. The flexibility and simplicity of forward contracts usually make them a better choice when compared to futures contracts.