What is currency hedging?
Currency hedging is similar to insurance, which you buy to protect yourself from an unforeseen event. It’s an attempt to reduce the effects of currency fluctuations. To hedge an investment, investment managers will set up a related investment designed to offset potential losses. In general, currency hedging reduces the increase or decrease in the value of an asset due to changes in the exchange rate. It’s an attempt to even out results.
How does currency hedging work?
Currency hedging starts by assessing the risk exposure and by choosing a hedging instrument.
The risk exposure is usually a foreign-currency-denominated commercial transaction defined as the payment (or receipt) of a fixed amount of foreign currency in exchange for the ticket (or delivery) of a fixed quantity of goods or services.
In most transactions, there is a period between the moment the transaction is initiated and the moment the foreign currency is paid or received.
Therefore, that period creates currency risk and the opportunity and the need for currency hedging.
The hedging instrument is the financial instrument that creates the offsetting position.
The most widely used foreign exchange hedging tool is a currency forward contract, also known as a ‘forward.’
A forward contract consists of a promise to exchange one currency for another on settlement day at a specified exchange rate.
Because size and delivery dates can be set on any terms, forward contracts are inherently flexible.
Forward contracts are considered ‘accounting friendly’—another reason for their widespread use.
About 90% of companies use them as the hedging instrument of choice.
Foreign currency futures and options contracts are the other two main FX hedging instruments.
Currency Hedging Example
An exporter with USD as its functional currency expects to sell finished goods for EUR 100,000 to a European client in two months.
The export is to be settled a month after the goods are delivered.
When the transaction is initiated, the spot exchange rate is EUR-USD 1.23, and the forward momentum is 1.25.
To hedge the currency risk, the exporter enters a forward contract to deliver EUR 100,000 on the date that payment is expected from the customer.
The counterpart to the forward contract agrees to pay, upon maturity, the difference between the forward rate and the spot rate on a notional amount of EUR 100,000.
What happens when both operations are settled, assuming that the spot rate has moved down to EUR-USD 1.18?
The exporter settles the forward contract with the cash proceeds of the EUR sale and receives USD payment on the forward contract.
Between the moment the sale was initiated and the settlement date, its value has declined by USD 5,000 (18,000 — 23,000).
This loss is offset by a USD 7,000 (25,000 — 18,000) gain on the forward contract.
The net FX gain of USD 2,000 results from the forward points, or the difference between the forward and spot rate when the hedge was entered into: EUR 100,000 x (1.25 — 1.23).
Decisions concerning how to implement currency hedging —i.e., what specific currency hedging strategy to implement— must be taken by the firm’s overall currency risk management.
In turn, the risk management framework will consider many different factors, like the company’s business profile or the risks it faces.
While the trend towards flexible business models appears to be irreversible, new technology solutions are being developed to fully support CFOs and treasurers in the task of hedging their currency exposure in ever more dynamic ways, regardless of the size of their companies.