Types of hedging strategies: A comprehensive guide

Is market volatility hurting your bottom line? Working with an experienced OFXpert to understand the world of hedging could be the solution. Follow along as we discuss different types of hedging strategies with our risk management OFXpert, Jake Trask.

Market volatility can mean lost money on foreign exchange (FX) transactions. That’s where hedging comes into play. 

Hedging is the process of protecting yourself, whether you are a consumer or business, from a future change in price. In foreign exchange, it works by taking a position that prevents you from losing out if the currency market moves against you, but you could also miss out on some benefits if the exchange rate for the currency pair you need to trade changes in your favour.

There are a number of ways you can employ this approach that can help protect your business’s profits from currency fluctuations.

Developing a hedging strategy is a three-step process beginning with gaining visibility into your FX exposure, defining your FX risk management goals, and then creating a customised hedging strategy specific to your needs and wants.

 “Hedging is basically practising risk management, when you hedge you are giving yourself protection against negative market movements,” said OFXpert, Jake Trask.

There are many different types of hedging strategies to suit a business’s unique needs. Each hedging strategy comes with its own set of advantages and disadvantages.

When working with an OFXpert, we get to know your business, your organisation’s needs, the challenges you face, and any areas of FX opportunity for your business. This helps us work with you to create a personalised hedging strategy that can help save you time and money.

One product that remains at the centre of hedging strategies is Forward Contracts. Forward Contracts are a ‘buy now, pay later’ option for businesses trying to take advantage of a positive rate today on a payment that needs to be paid in the future. 

One OFX client, North American Produce Buyers, discussed why they use Forward Contracts in hedging and how it has helped their business. “…produce can sometimes be unpredictable, bad weather can affect a crop so I use forwards, I like the stability and knowing that I’m not getting taken advantage of if the market dips,” Vice President of Finance, Steven Moffat said.

Now that we have defined Forward Contracts and how they can help a business, let’s dive into 4 of the most common hedging strategies for businesses. It’s important to remember that you can’t cancel a Forward Contract, so you need to be sure that your business needs the currency at the point you commit to it.

1. Forward Contracts for specific invoices

This is both a volatility tool and a simple risk management strategy. This strategy is ideal for businesses looking to book a 1:1 hedge for a given payment in the future.

For example, a business would receive an invoice they need to pay in 6 months, so their hedging strategy is to book a Forward Contract solely dedicated to that payable. That means the Forward Contract is for the same amount of money and matures on the same date as that payable is required. This can be a great strategy for smaller businesses that are new to hedging.

Remember, you need to accept that if currency volatility worked to your advantage, you would still have to abide by the contracted rate of exchange, and so you could miss out on potential upsides. The key benefit is knowing what your future invoice will cost you.

2. Flexible Forward Contracts for ongoing exposure

This is the same as option one, however, rather than using the currency on the maturity date, you decide to use some of the Forward Contract earlier than its maturity date. For example, if you committed to buying $100,000 USD for use by the end of the year, you could choose to use $50,000 now and $50,000 later. Your business can decide when and how much to draw down on the contract within the life of the contract.

This type of risk management can be great for businesses that are not sure when invoices will be payable but want to hedge against future market volatility.

3. Rolling Hedge

The Rolling Hedge approach to risk management is when a business books multiple Forward Contracts with different maturity dates.

For example, a business has a consistent need to buy £100,000 per month for the next 6 months and beyond. A Rolling Hedge would consist of booking 6 different Forward Contracts, 1 for each month. When each month’s Forward Contract matures, the business takes delivery of it and then books the next Forward Contract for 6 months into the future. This is a great strategy for businesses with somewhat predictable FX needs within 6 months.

4. Layered Hedge

This strategy also consists of multiple Forward Contracts with multiple maturity dates. These Forward Contracts would be for different amounts and mature at different times but are layered over one another in the same period of time.

In this approach, the near months are hedged with larger amounts of money and the further months are lighter, with smaller amounts of money. This approach offers more certainty over your FX costs in the short term, and greater flexibility in future months.

Choosing between one of these strategies can feel overwhelming, but that’s where our OFXperts come in to help you create a simple yet effective hedging strategy for your business, so you can stay focused on growing your business. 

At OFX, we have a dedicated group of OFXperts who focus on risk management and working with our clients to create tailored hedging solutions to fit their business goals.

Our OFXpert, Jean-Francois Giguere, starts with 3 simple steps to help our business clients choose the right FX hedging strategy for your businesses, “My risk management team is ready, experienced, and available to help you find the best hedging strategy for your business. It starts with a simple three-step process of gaining visibility into your business’s FX exposure, defining your risk management goals, and then creating a personalised risk management plan.”

1. Understand FX exposure volume:

How much foreign currency does your business transfer each year? If you have a large FX exposure volume, you may want to choose a more sophisticated hedging strategy that can help you reduce your risk exposure.

2. Define risk management goals:

Discuss what your business wants to gain from your hedging program. Do you want to protect your profits from currency fluctuations? Do you need more flexibility in your hedging strategy?

3. Create a personalised risk management plan:

The last step in the process is creating a unique hedging strategy that is personalised to your business and your risk management goals.

Once you and your OFXpert have completed this process, it is time to put the hedging plan into action. The best hedging strategy for your business will depend on your specific needs and circumstances. If you are not sure which hedging strategy is right for you, contact an OFXpert today.

When choosing the right hedging strategy for your business it is important to understand the pros and cons behind each approach.

Forward Contracts for specific invoices and ongoing exposure

Pros:

Cons:

Rolling Hedge and Layered Hedge approaches

Pros: 

Cons:

Remember that once you commit to a Forward Contract, you can’t cancel it, so you need to be sure that your business needs the currency.

A real-life example of a hedging strategy in practice can be seen through a Canadian-based exporter of energy. This business received USD payments from their customers and their need was to also sell in USD instead of the native CAD. This meant that their FX needs were consistent with good predictability. In early 2022, after reviewing their trading history and future expected demand, the hedging team worked with the business to develop  two hedging solutions. The Rolling Hedge strategy at a 75% ratio over 12 months.

The second option was a Layered Hedge at 80% for months 1-3, 60% for months 4-6, 40% for months 7-9, and 20% for months 10-12. The client elected to use the Layered Hedge strategy to take advantage of a smoother average rate over time. Since the USD/CAD pair oscillated between 1.3100 and 1.3800 at the time, the client was able to achieve an advantageous exchange rate over time.

No matter which one of these strategies seems like the best fit for your business, it is important to find an approach that helps protect your business from market volatility and reduces your risk exposure.

Need some more guidance to find the best strategy for your business? Contact an OFXpert today

See how Forward Contracts can help to protect you against market moves

Now you know more about hedging, get to know our Forward Contracts and try them for yourself.

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