In today’s global economy, companies and investors are constantly exposed to ongoing risk from fluctuating exchange rates. Yesterday, your foreign investments might have been profitable, but the next day, currency fluctuations will consume your profits.
Hedging against currency comes in at this point. But what exactly is currency hedging, and how do you do it?
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This complete guide walks you through everything you should know about insuring your finances against out-of-control currency fluctuations.
Currency Hedge Meaning
Currency hedging is a financial strategy that helps protect against negative exchange rate movements. It’s similar to insurance for your cross-border investments or business transactions.
When businesses or investors deal in multiple countries, they’re exposed to exchange rate or currency risk. This very risk refers to currency movements that may hurt the value of their investment or business transactions.
Currency hedging seeks to reduce or eliminate this risk by employing a range of financial instruments.
The primary intention is not to make profits out of the currency movements but to introduce stability into the otherwise volatile situations.
Hedging assists organizations in stabilizing the exchange rate of foreign currency transactions into local currency. By doing so, currency hedging enhances the predictability of aspects like financial planning and budgeting.
Why Currency Hedging Matters
Confused as to why large firms hardly ever give concern to the uncertainty of exchange rates?
Generally, the reason will be the right hedging practice.
Think of this. A small exchange rate fluctuation can have a huge impact on your bottom line if you’re transacting with lots of money across borders.
A 5% negative exchange rate movement on a $1 million transaction is a $50,000 loss, which is not something most businesses should risk overlooking.
Currency hedging offers:
- Protection from unforeseen market movements
- Predictability of cash flows and financial planning
- Stability in profit margins for cross-border businesses
- Less financial stress when transacting across borders
Real-World Currency Hedging Examples
Let’s take a deep dive into this concept with some real-world examples:
Example 1: The Forward-Thinking Importer
A US company is planning to buy materials for €500,000 from a German supplier in six months.
Assume the current rate is $1 = €0.85, so the price would be around $588,235.
But the firm fears that the dollar will depreciate against the euro in the next six months and render the purchase costly.
As a protection against this risk, they sign a forward contract to fix the current exchange rate for the future acquisition.
Six months later, assume that the exchange rate has indeed moved to $1 = €0.80.
Without hedging, the company would be paying $625,000—a total extra $36,765.
But thanks to the forward contract, they still pay only $588,235, which is a huge amount saved.
Example 2: The Protective Loan Strategy
MM Corporation, a US company, owes a €50,000 loan to a French bank.
If the value of the dollar falls relative to the euro, it will take more dollars to pay this off.
To insure against this, the company purchases a foreign currency forward contract fixing an exchange rate of $1 per €0.93, so they will pay $53,764 independent of what the market does.
As of the maturity date, the dollar actually declined to $1 = €0.90 such that MM would normally need to pay $55,556 on the repayment of the loan.
However, they only have to pay $53,764 through their forward contract, while the third party has to absorb the $1,792 difference.
Types of Currency Hedging
Currency hedging is not a one-size-fits-all solution. Conditions vary:
Fair Value Hedges
They shield current assets or liabilities from fair value fluctuations due to exchange rate movement.
An example is a firm that has foreign currency-denominated bonds: it can hedge with a fair value hedge to guard against fluctuation in the value of the bonds.
Cash Flow Hedges
Applied in likely forecast transactions, such hedges are protecting against future uncertainty of cash flows.
An entity to be paid in the future in a foreign currency can apply a cash flow hedge to hedge against future reduction of the amount received when converted in the local currency.
Perfect Hedges
These entirely separate both risk and potential gain related to a currency.
They’re accomplished by holding short and long positions simultaneously in the same currency pair, essentially nullifying any market movement’s effect.
Effective Currency Hedging Strategies
Curious about knowing how the experts hedge against currency fluctuations?
Research-backed strategies always give you an upper hand while hedging currencies.
Here’s my take on some of the best techniques being used in the market today:
1. Opposite Position Strategy
The method is to enter an opposite position of the same currency pair. For instance, if an investor is long on EUR/USD, he would short the same volume of EUR/USD.
This is a “perfect hedge” that erases both risk and potential profit.
When to use it: When you have a permanent position but are looking for short-term hedging against volatility, say ahead of significant economic announcements.
2. Options Contracts
Options give the right, but not the obligation, to sell or buy a currency at an agreed price by a certain time.
For example, a business anticipating future exchange receipt can buy put options in the currency to protect against its depreciation.
When to use it: When you desire flexibility with protection against negative movements.
3. Money Market Hedging
This is achieved by buying the foreign currency at the prevailing spot rate, holding it in a money market account until the payment date, and using that money to make the payment.
When to use it: For firms with recurring cash needs in foreign currencies, particularly those involving exotic currencies with shallow options markets or forward markets.
4. Forward Contracts
These enable two counterparties to agree to exchange a fixed amount of currency at a set date in the future at a pre-determined exchange rate before that date.
When to use it: Anytime you want a guarantee of future exchange rates for specific transactions.
5. Currency Swaps
These include the trading of cash flows in various currencies and can reduce currency risk otherwise potentially affecting portfolio returns.
When to use it: Where hedging is required for longer horizons, particularly for firms with continuous international activities.
Is Currency Hedging Worth It?
The million-dollar question: Should you hedge, or not hedge, your currency exposure?
The answer depends on certain considerations such as your risk appetite, volume of transaction, and existing situation. Things you ought to know:
Benefits of Currency Hedging
- Guarantees certainty of transaction costs in the future
- Enabling enhanced planning and budgeting based on real costs
- Ensures peace of mind against market fluctuation
- Facilitates flexibility in execution (you can hedge only a proportion of exposure)
Currency Hedging Risk
- Has a cost—either direct premium or an opportunity cost
- Frictions may arise in coordinating and administering, particularly for simultaneous transactions
- May be restrictive in obtaining benefits from optimal movement in the exchange rate
- Require frequent monitoring and adjusting
In a business with sporadic foreign trade dealings, hedging cost for predictability would prevail over the cost.
But in the case of unusual transactions or relatively stable currency pairs, the cost could not possibly be justified to have protection remain in effect.
Currency Hedging Cost
Nothing in finance is free, and that includes protection against currency risk. Costs must be understood before a hedging tool can be applied.
Various hedging instruments carry different cost structures:
- Forward contracts usually do not involve a front-end premium paid but do involve opportunity costs if the rates shift in your favor.
- Options involve a front-end premium payment that is based on aspects like volatility, time to expiry, and strike price.
- Money market hedges are tied to transaction costs, potential interest rate differentials, and administrative fees.
On the other hand, indirect costs include:
- Administrative burden of hedging strategy management
- Futures contracts’ potential margin requirements
- Accounting complexity of hedges regarding financial statements
When assessing whether hedging is worth the cost, weigh the direct costs and these underlying costs against the potential protection.
FAQs
Q. What is an example of currency hedging?
An American firm buying German supplies can buy euros today at the prevailing rate and wait until the payment date.
Alternatively, it can buy a forward contract that fixes today’s rate for later exchange.
Q. What is the currency hedging strategy?
Currency hedging strategies are risk management strategies involving the use of instruments such as forward contracts, options, and money market accounts.
This is done to hedge against unfavorable exchange rate movements and obtain certainty regarding the future cost of transactions.
Q. Is currency hedging good?
Currency hedging is hedging against unfavorable exchange rate movement and budget certainty, but it is not free.
Whether or not it is “good” will be dependent on your particular situation, risk tolerance, and relative cost of the hedge.
Q. Can you lose money when hedging?
Yes, it happens through premiums paid, opportunity costs (if rates shift in a favorable direction for you), or if the hedge does not exactly align with your exposure.
Hedging converts potential for greater gain into insurance against potential greater loss.
Conclusion
Currency hedging is an advanced technique for financial risk management in our constantly evolving globalized economy.
Though not inexpensive or simple, the security and certainty it provides can be priceless to transnational businesses.
Understanding and applying the right currency hedging techniques can mean the difference between financial security and wild uncertainty. This is regardless of whether you’re a multinational corporation or an investor with foreign holdings.
Remember: Hedging is not intended to make you the highest returns but to limit risk.
By doing so, you can concentrate on your core investment strategy or business without being perpetually concerned about exchange rate movements.
Pained by financial indecision?
Adam is an internationally recognised author on financial matters with over 830million answer views on Quora, a widely sold book on Amazon, and a contributor on Forbes.
