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, Trent Mcilroy.

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

Hedging is the practice of creating a risk management strategy 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 customized hedging strategy specific to your needs and wants.

 “Hedging is when you practice risk management for your business. When you hedge, you are helping to protect your business from negative market movements,” said OFXpert, Trent Mcilroy.

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 organization’s needs, the challenges you face, and any areas of FX opportunity for your business. This helps us work with you to create a personalized hedging strategy that can help save you time and money.

One product that remains at the center 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.

1. One-off Forward Contracts

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 is a great strategy for smaller businesses that are new to hedging.

2. Open Forward Contract

This strategy consists of using a one-off Open Forward Contract. The Open Forward Contract gives more flexibility to businesses because they don’t have to define a fixed delivery date. Your business can decide when and how much to draw down on the contract within the open window.

This type of risk management is 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 made up of multiple Forward Contracts with different maturity dates.

For example, a business has a consistent need to buy AU$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 is ideal for larger businesses with more complex needs.

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 at no additional cost, 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, Trent Mcilroy, has a simple 3-step approach to helping your business find the right hedging strategy, “At OFX our risk management team is equipped with the expertise to help you find the best hedging strategy for your business. We start with a 3-step process to gain visibility into your business’s currency exposure, understand your risk management goals, and finally to create a bespoke 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 personalized risk management plan:

The last step in the process is creating a unique hedging strategy that is personalized 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.

One-off Forward Contracts and Open Forward Contracts strategies

Pros:

Cons:

Rolling Hedge and Layered Hedge approaches

Pros: 

Cons:

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 recommended 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 protects 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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