What is currency hedging?
You’ve identified your business has foreign exchange risk because of the transactions it makes internationally. Find out how a currency hedging strategy could help.
So, you’ve identified your business has foreign exchange risk because of the transactions it makes internationally. But what can you do about it?
There are many methods companies or individuals can use to help reduce the amount of risk they are taking with their currency trades. One of these is to use something called ‘hedging’ which could help prevent yourself or your business from facing rising costs due to fluctuating exchange rates.
Here, Hamish Muress, one of our OFXperts, goes through some of the most commonly asked questions to help you get a clearer understanding of how this process works and whether it is suitable for you and/or your business.
What is hedging?
Have you ever purchased a foreign currency at a favourable exchange rate before an international holiday? If so, you’ve already used a hedging strategy.
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.
How can hedging work for my business?
The theory and logic behind hedging is that it removes an element of risk and uncertainty.
The amount you want to ‘hedge’ may change depending on the amount of risk you can afford to take, and the way that currency markets are expected to move. You may want to prevent any risk of loss if, for example, your business has completed a contract to buy at an agreed cost from a supplier, or you are buying a property that you could not afford if rates moved against you. It is a simple way of ‘insuring’ yourself from any rising costs.
How would I do that?
You can purchase a Forward Contract and ‘fix’ the rate available to you for an agreed amount for a period of time, say, up to one year. Or, if you can afford to take a bit of risk, you might want to lock in at today’s price for part of the money you would need to transfer, but leave the remainder to a ‘spot rate’ (on the day) in the future, as that gives you some chance of accessing a higher rate if the currency pair moves to your advantage.
Can you give me an example?
Sure. So, if a company in the UK was importing small bolts from China as part of their manufacturing line, they may have to pay for those bolts in US dollars. Now, the business may be worried that the exchange rate for the pound versus the US dollar could be worsening in the future which could increase the costs to import the bolts. If the business’ budgeted rate to pay for their US dollar is GBP/USD 1.25 they may look to lock in this exchange rate for the next year if they are worried it could drop below 1.20 - only a 4% swing in the rate - and wipe out any profit the company makes.
However, if that same company knew it could afford 30% of the transaction to go down to GBP/USD 1.18, then they could use a Forward Contract to fix 70% of their costs and leave the remaining 30% free to benefit if there is any upside for them on the exchange rate. While there is the potential of upside, this 30% is also at risk if there is any downside for them on the exchange rate.
How can I get started?
Still not sure if hedging is for you? Check out the article ‘Is currency hedging right for your business’ or speak to an OFXpert who can discuss the options for you to choose a currency strategy and products for you.