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How do businesses use hedging strategies to manage exchange rate risk?

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If you run a business that deals with foreign currencies, you know how exchange rate fluctuations can affect your profits and cash flow. Exchange rate risk is the possibility of losing money or gaining less than expected due to changes in the value of one currency relative to another. To manage this risk, businesses use various hedging strategies, which are methods of reducing or eliminating exposure to currency movements. In this article, you will learn about some common hedging strategies and how they work in practice.

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Alex Axentiev

Making global finances simpler through automation and analytics

1 Forward contracts

A forward contract is an agreement between two parties to exchange a fixed amount of one currency for another at a predetermined rate and date in the future. For example, if you are a US-based exporter who expects to receive 100,000 euros from a European customer in three months, you can lock in the exchange rate today by entering into a forward contract with your bank. This way, you can avoid the uncertainty of the future spot rate and protect yourself from potential losses if the euro depreciates against the dollar. Forward contracts are customized and flexible, but they also involve counterparty risk, which is the risk that the other party will default on the contract.

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Alex Axentiev

Making global finances simpler through automation and analytics
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FX Forward contracts are the most used instruments in FX hedging. They can be used to convert specific financial commitments (e.g. payables or receivables) from foreign currency to the "home" one and thus eliminate FX gain and losses. Longer-dated forwards can help smooth the value of future foreign currency cashflows and make financial results more stable and predictable despite currency swings. Forwards are best used to hedge FX risks for highly certain exposures that need to be hedged. Entering into forwards in other situations may instead create additional risks. FX forward prices are less transparent than spot prices so it is important to demand transparency from your bank or FX broker, or check prices from multiple providers.

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2 Futures contracts

A futures contract is similar to a forward contract, except that it is standardized and traded on an exchange. Futures contracts specify the quantity, quality, and delivery date of a currency, as well as the margin requirements and settlement procedures. For example, if you are a UK-based importer who needs to pay 50,000 US dollars to a US supplier in six months, you can buy a futures contract for USD/GBP today and lock in the exchange rate. This way, you can hedge against the possibility of the pound depreciating against the dollar. Futures contracts are more liquid and transparent than forward contracts, but they also involve more transaction costs and market risk, which is the risk of losing money due to unfavorable price movements.

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3 Options contracts

An options contract is a contract that gives the buyer the right, but not the obligation, to buy or sell a currency at a specified price and date. For example, if you are a Canadian-based investor who plans to buy 100,000 Australian dollars worth of Australian stocks in one month, you can buy a call option for AUD/CAD today and secure the right to buy Australian dollars at a fixed rate. This way, you can benefit from any appreciation of the Australian dollar against the Canadian dollar, while limiting your downside risk to the premium you paid for the option. Options contracts are more flexible and versatile than forward and futures contracts, but they also involve higher premiums and volatility risk, which is the risk of losing money due to changes in the option's value.

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Alex Axentiev

Making global finances simpler through automation and analytics
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FX options can be valuable in situations with heightened uncertainty about the exposures to hedge. For instance, they can used when the underlying exposures are less than certain themselves. Purchasing an FX option helps protect from the negative scenarios that could otherwise affect the value of the underlying cashflows. At the same time, it can be done without taking the risks of having to unwind the hedge if the underlying exposure does not materialise. In exchange for this asymmetric profile, the buyer of the option pays a premium, akin to the insurance premium.

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4 Currency swaps

A currency swap is an agreement between two parties to exchange principal and interest payments in different currencies over a period of time. For example, if you are a Japanese-based company that borrows 10 million US dollars from a US bank at a fixed interest rate, and you have a US-based partner that borrows 1 billion yen from a Japanese bank at a floating interest rate, you can swap your cash flows and reduce your exposure to exchange rate and interest rate fluctuations. This way, you can match your income and expenses in the same currency and avoid currency conversion costs. Currency swaps are more complex and long-term than other hedging strategies, but they also involve lower margins and credit risk, which is the risk of losing money due to the default or downgrade of the other party.

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5 Here’s what else to consider

This is a space to share examples, stories, or insights that don’t fit into any of the previous sections. What else would you like to add?

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Alex Axentiev

Making global finances simpler through automation and analytics
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There are different objectives for hedging, and it is important to agree on what is right for your business. Discuss it with senior management and make sure the goals are understood and aligned with the business. Best hedging strategies are optimised for specific goals and aim to minimise the costs. Most common hedging programmes cover balance sheet hedging (with the aim to remove P&L effect of balance sheet items such as APs or ARs in foreign currencies) and cashflows hedging - with the aim to make future financial results more predictable and stable from one accounting period to the next.

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Alvaro Costa

Finan?as e Controladoria
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Avalie manter parte das receitas de exporta??o em um conta no exterior, uma maneira natural de fazer hedge, usando a própria receita da empresa.

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How do businesses use hedging strategies to manage exchange rate risk?

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1 Forward contracts

2 Futures contracts

3 Options contracts

4 Currency swaps

5 Here’s what else to consider

Business Management

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How do businesses use hedging strategies to manage exchange rate risk?

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1 Forward contracts

2 Futures contracts

3 Options contracts

4 Currency swaps

5 Here’s what else to consider

Business Management

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