Currency hedging is the creation of a foreign currency position, simply known as a “hedge“, with the purpose of offsetting any gain or loss on the underlying transaction by an equal loss or gain on the hedge.
Whether the future exchange rate goes up or down, the company is protected because the hedge effectively “locks in” a home-currency value for the exposure.
A company that undertakes a currency hedge is therefore indifferent to the movement of market prices.
Hedging differs from speculation, where a currency position is taken in anticipation of an expected change in foreign currency rates.
Currency hedging is the most important element of a company’s currency risk management.
Depending on a firm’s competitive profile, on the nature of the markets in which it operates and on the goals set by its management, a firm can choose between several possible currency hedging strategies, most of which can be executed by means of software solutions that automate the entire process.
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 receipt (or delivery) of a fixed quantity of goods or services.
In most transactions, there is a time span between the moment the transaction is initiated and the moment the foreign currency is to be paid or received.
That time span creates currency risk and therefore the opportunity and/or 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’ time.
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 rate 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 on the day 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— need to be taken in accordance with the firm’s overall currency risk management.
In turn, the risk management framework will consider a number of different factors, like the company’s business profile or the risks that 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.