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 current 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.
About 90% of companies use them as the hedging instrument of choice. Foreign currency futures and options contracts are the other two main forex hedging instruments.
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.
Vincent Nyagaka is a Professional Trader, Analyst &. He has been actively engaged in market analysis for the past 7 years. He has a monthly readership of 100,000+ traders and has taught over 1,000 students since 2014. Vincent is also an experienced instructor and public speaker. Checkout Vincent’s Professional Trading Course here.