Currency Hedging

In this article, We learn about "Currency Hedging ".Let's Go!

Currency Hedging is the establishment of a foreign currency position, referred to simply as "hedging", for the purpose of offsetting any gain or loss on the underlying transaction by an equivalent loss or gain on the hedge.

Whether exchange rates rise or fall in the future, the company is protected because the hedge effectively "locks in" the local currency value of the exposure.

A currency-hedging firm is indifferent to changes in market prices .

Hedging differs from speculation, which is taking a currency position in anticipation of an expected change in the exchange rate of a foreign currency.

Currency hedging is the most important element in a company's currency risk management.

Depending on the company's competitive situation, the nature of the market in which it operates, and the goals set by the management, a company can choose between several possible currency hedging strategies, most of which can be implemented through software solutions that automate the entire process .

How does currency hedging work?

Currency hedging begins with assessing your risk exposure and selecting a hedging instrument.

An exposure is typically a commercial transaction denominated in a foreign currency, defined as the payment (or receipt) of a fixed amount of foreign currency in exchange for receipt (or delivery) of a fixed quantity of goods or services.

In most transactions, there is a time span between the moment the transaction is initiated and the moment the foreign currency is paid or received.

This time span creates currency risk, creating the opportunity and/or need for currency hedging.

Hedging instruments are financial instruments that create offsetting positions.

The most widely used foreign exchange hedging instrument is the currency forward contract, also known as a "forward" .

A forward contract consists of a commitment to exchange one currency for another at a specified exchange rate on the settlement date.

Forward contracts are inherently flexible since size and delivery dates can be set on any terms.

Forward contracts are considered "accounting friendly" - another reason for their widespread use.

Approximately 90% of companies use it as their preferred hedging tool.

Foreign currency futures and options contracts are the other two main forex hedging instruments.

Currency Hedging Example

An exporter whose functional currency is the U.S. dollar expects to sell EUR 100,000 worth of manufactured goods to European customers within two months.

Export settlement is one month after shipment.

When the transaction is initiated, the spot rate is EUR/USD 1.23 and the forward rate is 1.25.

To hedge against currency risk, the exporter enters into a forward contract to deliver €100,000 on the date the customer expects to pay.

The counterparty to the forward contract agrees to pay at maturity the difference between the forward rate and the spot rate in the notional amount of EUR 100,000.

Assuming the spot rate has fallen to EUR/USD 1.18, what happens on the day the two operations settle?

The exporter settles the forward contract with the cash proceeds of sales in euros and receives payment in dollars for the forward contract.

The value has decreased by $5,000 (18,000 — 23,000) from the date of sale to settlement date.

This loss is offset by a gain on the forward contract of $7,000 (25,000 — 18,000).

The net foreign exchange gain of USD 2,000 is derived from the forward point, or the difference between the forward rate and the spot rate when hedging: EUR 100,000 x (1.25 — 1.23).

How to implement currency hedging, that is, what specific currency hedging strategy to implement, needs to be determined based on the company's overall currency risk management.

In turn, a risk management framework will consider many different factors, such as a company's business profile or the risks it faces.

While the trend toward flexible business models seems irreversible, new technology solutions are being developed to fully support CFOs and treasurers in hedging currency risk in a more dynamic manner, regardless of company size.

If you want to learn more foreign exchange trading knowledge, please click: Trading Education.


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