Many people talk about currency hedging as a risk management strategy, but what is it and how does one do it?
A Forex hedge is a contract that is implemented to protect an anticipated position from an unanticipated change in exchange rates. Simply put, it is a strategy to protect against losses in an uncertain market environment.
Many companies involved in global markets use hedge strategies to guard against Forex volatility and currency risk. They may do so to protect income flow when dealing in local currencies, or if they need to import goods or raw materials from foreign markets.
At the same time, private investors who might have a portfolio containing a range of positions in different assets spread across global markets will similarly benefit from using a hedge in order to protect profits upon repatriation to their home country.
Below we have set out a brief introduction and description of the types of instrument that can be used as elements of a hedge strategy. These could be of particular interest for businesses that have a lot of dealings in foreign currency and wish to reduce their FX exposure risk.
Consider an example of a company using an FX hedging strategy to protect their income stream. A company headquartered in the UK which makes engineered products for the European motor industry through a German subsidiary wants to ensure the Pound value of its sales will be within a certain margin when they repatriate the profits at the end of the sales period.
In order to do this the company takes out a Forex option with a broker to sell Euros and buy Pounds at a particular rate by a certain date. Note that the company is not obliged to use this option, it is simply there if they need to use it. If, in the meantime, the Pound weakens, the option will not need to be called upon and the company is likely to make a profit on the exchange rate difference (minus the cost of taking out the option).
If, on the other hand, the Pound strengthens against the Euro, the company can call on the hedging option and repatriate their funds at a more favourable exchange rate than the market spot rate.
The key thing to note here is that if the transaction had been left unprotected - that is, no FX hedging option had been taken out - there would have been a considerable risk of the profits being eaten into by an unfavourable exchange rate.
The most common methods of hedging currency trades involve looking at spot contracts, foreign currency options and currency futures, but there are others. Spot contracts are the everyday trades made by retail Forex traders on a moment-by-moment basis. Because spot contracts have a very short-term delivery date, they are not the most effective currency hedging vehicle as they leave the trade unprotected against wider market movements.
Futures contracts are agreements to buy or sell a certain amount of a particular currency pair at a particular future date when the contract matures. Futures contracts are widely traded and are popular due to their high liquidity and options for making a profit but they do not offer much protection in a wider risk management sense.
In terms of risk management to guard against currency risk, a popular hedging strategy used for securing an agreed upon exchange rate is through the use of a forward contract. This allows for a certain exchange rate (forward rate) to be set for a certain point in the future, giving a degree of security when considering future cash flow or purchase obligations. While forward contracts guard against spot rate volatility they are one of the less flexible FX trading instruments and require rolling over at the end of each time period.
A stop loss is similar to a forward contract in that the buyer agrees a lower exchange rate parameter with the FX broker, meaning that if an agreed upon lower level is breached the contract is invoked and any further losses are halted. Instead of using spot prices, forward contracts or futures contracts, currency options are one of the most popular methods of hedging. As with options on other types of securities, foreign currency options give the purchaser the right - but not the obligation - to buy or sell the currency pair at a particular exchange rate at some point in the future.
Options are far more flexible than any of the other widely used hedging instruments as they offer security without the obligation to call on the contract. Thus, the buyer is offered protection against currency exposure, and the seller charges a fee whether the option is called upon or not.
Forex hedging strategies are just as relevant for private investors as they are for companies doing international business. Risk averse investors may have a number of investments in their portfolio and is most likely to use a hedging strategy to reduce their currency market exposure and attain a greater degree of financial security. Here's an example:
Let's say a US-based company invested a certain amount of Dollars buying equities in a French pharmaceutical company in 2019. That company was then credited with helping to develop a Covid-19 vaccine that made world headlines, causing its stock price to jump 100%. The US-based investor then decides to cash out of her position from this trade and repatriate the profits to the US - however, in the meantime, the Euro has weakened substantially against the US Dollar, meaning far fewer profits once exchange rate devaluation has been taken into consideration.
Our investor was not willing to accept this currency exposure and had taken out a currency option product with a broker for the greater part of her investment, thus guaranteeing a favourable exchange rate. As such, her portfolio is able to benefit from the appreciation in the stock value, while avoiding the currency risk simply by hedging her currency options in advance.
Foreign exchange hedging is all about reducing risk and protecting against adverse price movement. For companies and individuals with investments in overseas markets or with financial exposure to volatile sectors, considering a hedging solution is a must. Aside from the main FX risk hedging instruments there are a number of other popular tools which are widely used by Forex traders and risk managers. These include:
Contract for Differences, or CFDs, are complex financial instruments that are usually highly leveraged. They are a type of derivative contract that pays the difference in settlement price without any actual delivery of product. Being settled in cash, CFDs are popular among currency and commodities traders.
Derivatives are financial instruments derived from the value of a physical asset, meaning they can be traded without the 'risk' of the physical delivery of an asset or commodity. Derivatives traders make bets on the price of an asset moving up or down, meaning CFDs are traded on the basis of exchange rate futures.
Currency swaps are the final type of hedging instrument we will consider. In terms of risk management, a currency swap is a contract that allows for an exchange of interest on a currency pair. Companies doing business in foreign markets often use currency swaps in order to get more favourable loan rates. Swaps are considered to be a form of currency exchange and are a useful tool for risk managers.
If you are a company engaging in overseas Forex transactions - a hedge strategy should be a part of your overall risk management plan.
If you are concerned that FX movements could put your cash flow or portfolio at risk, Currency Solutions can offer guidance on ways you can hedge your currency exposure.
Trading in currency pairings always carries a risk, but by using a hedge you will be able to guard against adverse price movements and protect your business and investment against the pitfalls of the Forex market.
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