Understanding how things work in the world of finance can be quite difficult. Forex or FX hedging often confuses business owners who trade internationally.
Simply, FX hedging helps people minimise the risk of losing money. Specifically, when exchange rates change while they are trading in foreign currencies. The basic idea is simple. Understanding how the process works and how beneficial it is can be confusing.
This article will provide a good basic introduction to FX hedging. While it may look complicated understanding how FX hedging works is actually simple. With the right resources and examples, FX hedging can help business owners manage FX risks and save profits.
What is FX Hedging?
When people minimise the risk of losing money on the foreign currency markets. FX hedging refers to a strategy of minimising risks that come with trading foreign currency.
Why Do Businesses Do FX Hedging?
Any business that buys or sells in the foreign currency market is at risk of suffering losses. If exchange rates go the wrong way, businesses that sell goods or services abroad are the ones most at risk. The easiest way to show how this works is with this example...
A Tale of A British Cheese Wholesaler
A UK cheddar cheese wholesaler who sells to countries in the EU is at risk from exchange rate changes when they sell cheddar cheese in euros.
If this wholesaler charges a customer from the EU €1000 immediately after sending goods, they might expect to receive £850 based on exchange rates on the day of the sale. But, the customer usually doesn’t have to pay straight away. They may not have to pay the invoice for something like three months. By the time the customer pays the value of the pound may have dropped and when the customer pays the bill of €1000, this converts to, say, only £800.
This is known as currency loss and the risk of it happening is currency risk.
Trading in foreign currencies is risky and can lead to losses. For this reason, businesses carry out forex hedging. FX hedging is just a way of reducing the risk. It allows businesses to trade internationally with much more certainty about how much they will earn.
Businesses That Import Can Do Forex Hedging
It is not just businesses that sell abroad that can do FX hedging. Those who import from abroad are also at risk from exchange rate changes. That said, those who are usually most at risk are those who sell to foreign markets. Export businesses are more likely to hedge their FX risks.
Don’t Exchange Rates Also Change Favourably?
It is true that exchange rates may change favourably for businesses that trade internationally, as well as unfavourably. While this is the case, the majority of businesses suffer losses as a result of currency risk and most businesses have a need to reduce the risk that they expose themselves to.
It is also worth pointing out that some forex hedging strategies allow businesses to both reduce the risk of loss and to capitalise on opportunities when exchange rates change in a favourable way.
How Businesses Benefit from Forex Hedging
The circumstances of different businesses vary and, as a result, the ways in which they are at risk when trading in foreign currencies varies. However, the fundamental risk of exchange rate changes stays the same, and the fact that businesses, which trade in foreign currencies, can save themselves money by carrying out a forex hedging strategy that suits them stays the same.
Does Everyone do Forex Hedging?
Now that it is clear that businesses are at risk from trading in foreign currencies and that there are ways of reducing this risk, it seems obvious to ask if everyone is already doing it.
The fact is that, while large businesses have been carrying out forex hedging for a long time, the vast majority of small and medium-sized enterprises (SMEs) do nothing about it. This is because, traditionally, the process of carrying out forex hedging has been so complicated and time-consuming that only the biggest businesses have been able to do it.
This lack of ability to carry out forex hedging is costly to SMEs.
Only a very small number of SMEs currently protect themselves from currency risk.
There is a huge opportunity for SMEs to save themselves money when trading internationally. Bound exist to simplify forex hedging for small and medium-sized enterprises and to provide quick and simple ways for them to carry it out.
How do Businesses Carry Out Forex Hedging?
Spot trades are instant trades. Businesses from separate currencies agree to exchange money quickly at the ‘spot exchange rate’. The spot exchange rate is the agreed exchange rate at the time of sale. Usually, under a spot trade, the buyer will agree to settle the invoice within 48 hours of the agreement being made.
Spot trades are simple, instant trades that remove the risk of exchange rate fluctuation. While spot trades can be done directly between seller and buyer, many businesses choose to do them through a third party. Bound are able to provide spot trades and use the live interbank rate to ensure that trades done through them are done with the best exchange rate available.
On the Bound platform, a spot trade can be carried out in a matter of minutes without the need to speak to a bank or broker. This compares to traditional methods which are often costly and time-consuming.
Under a forward trade, the buyer and seller agree to an exchange rate and the buyer then has to pay what they owe at this rate within a fixed time period.
This simple agreement protects against unexpected losses and allows businesses to operate without the need for immediate payment.
Many businesses can’t function under spot trades and having the ability to delay payment can be very useful. Delayed payments with pre-determined exchange rates allow businesses of this kind to operate without the uncertainty which comes with exchange rate fluctuations.
Businesses are able to operate with much more clarity about what their future cash flow will be. Being able to plan cash flow clearly under a forward trade helps businesses to operate more smoothly when they are trading in foreign currencies.
Forward trades are often best handled through a third party. Bound provides forward trades on their platform and they can be booked in under a minute.
Option trades are similar to forward trades, with the main difference being that they offer the opportunity to execute a trade at a point when exchange rates move in your favour.
Under an option trade, the buyer and seller agree to a minimum exchange rate for payment and also agree that it will be made by a certain date. This is similar to forward trades. However, under an option trade, if the exchange rate moves in one party’s favour it is possible for them to choose not to trade at the agreed minimum exchange rate. Instead, they can take a more favourable spot trade.
Option trades both insure against losses and also allow the opportunity for businesses to benefit when exchange rates move favourably.
As with forward trades, option trades are often best handled through a third party. Bound provide option trades on their platform and, as with spot and forward trades, the process of carrying one out is simple.
FX Hedging in A Nutshell
While at first forex hedging may seem to be a complicated subject, it is not actually that difficult to become an accomplished FX hedger. If your small or medium-sized enterprise trades in foreign currencies, it may well be worth taking a look into whether or not you could save money with forex hedging.
Any business which trades in foreign currencies is at currency risk and taking measures to reduce this risk can save huge amounts of money. Bound aims to simplify the world of forex hedging and to enable all businesses which trade in foreign currencies to benefit from it by providing quick and simple tools on our FX hedging platform.