FX Hedging

 

Summary:

• An FX hedge is the use of a foreign currency trade to protect financial positions from adverse fluctuations in exchange rates caused by currency volatility.
• Common FX hedging instruments include: FX forward contracts, FX options, and FX swaps.

 

FX hedging explained:

• What is FX hedging?
• How does FX hedging work?
• How to hedge FX risk
• FX hedging example
• What are the benefits of FX hedging?
• FX hedging solutions
• FAQ's

 

What is FX Hedging?

Foreign exchange (FX) hedging is a risk management strategy designed to protect businesses and investors from unfavourable fluctuations in exchange rates caused by currency volatility.

Hedging in the FX market involves taking an offsetting position against an existing exposure to minimise the impact of currency fluctuations on investment performance. This strategy helps reduce risk by balancing potential losses with gains from the opposing position.

Effective hedging in FX can help businesses focus on their core activities without being overly concerned about the adverse impacts of exchange rate fluctuations.

 

How does FX hedging work?

FX hedging works by using financial instruments, such as derivatives, to lock in an exchange rate and price for a future transaction. Businesses and investors use different derivatives to protect themselves from unfavourable market movements.

Common FX hedging instruments include FX forward contracts, FX options, and FX swaps, which allow businesses and investors to secure a specific exchange rate or set terms for future currency exchanges. This provides stability and predictability in financial planning and enables them to effectively hedge FX exposures.

 

How to hedge FX risk

FX Forward hedging:

An FX forward is an agreement to exchange two different currencies at a predetermined rate on a specific future date, with the rate being set at the start of the contract.

FX forwards are used to secure an exchange rate for future transactions, protecting against currency fluctuations and effectively hedging FX risk. These contracts are over-the-counter (OTC) derivatives, meaning they are traded directly between two counterparties and can be tailored to meet specific hedging needs.

Rolling hedging:

For long-term investments with uncertain timelines and values, it's important to have a hedging strategy for FX that doesn't depend on a static settlement date.

In rolling hedging, forward trades are initiated for a certain duration (usually 1 or 3 months) and are then "closed" shortly before settlement by executing a trade in the opposite direction. The closing of the trades could lead to either a profit or loss.

The strategy is termed rolling hedging because, after closing existing positions, the fund immediately opens new ones for the next month or quarter, a process known as rolling the positions, as a result, maintaining the FX exposures during the rolling process.

FX dynamic hedging:

FX dynamic hedging is a risk management strategy that involves continuously adjusting the FX hedging positions of currency exposures to dynamically manage the currency risks.

This technique is commonly used in options trading to maintain a delta-neutral stance by buying or selling underlying assets as their market prices fluctuate, thereby minimising risk.

Dynamic hedging offers a more adaptable approach than static hedging strategies to hedge FX exposure, might lead to reduced cash flow volatility.

 

FX hedging example

Company A, based in the US, has agreed to purchase machinery from a UK supplier for £10,000,000. The payment is due in 12 months, but Company A is concerned that the GBP/USD exchange rate could move unfavourably, increasing the cost of the purchase in U.S. dollars.

FX hedging using forward contract:

To hedge FX risk, Company A enters in a currency forward contract with a bank to secure the current exchange rate, settling in 12 months when their payment is due.

Sell USD/Buy GBP Forward rate: 1.30

Contract amount: £10,000,000

Price in USD: $13,000,000

Exchange:

The currency forward contract is settled 12 months later. Company A pays their counterparty bank $13,000,000 in exchange for £10,000,000.

By using a forward contract to lock in the exchange rate, Company A has avoided any potential losses as a result of adverse market movements.

 

What are the benefits of FX hedging?

Hedge FX exposure:

By utilising FX hedging strategies, businesses and investors can offset the potential profits and losses that might arise due to the movements of foreign currency values against their base currencies. This ensures more stable financial outcomes and reduces the unpredictability in international transactions.

Provide certainty in forecasting cash flow:

By securing an FX rate in advance, businesses and investors can gain a higher level of certainty in their financial planning. This enables more precise cash flow forecasting, which facilitates improved budgeting and financial management. It also allows for informed strategic decisions without the risk of adverse currency rate fluctuations affecting financial stability.

 

FX hedging solutions

MillTechFX assists businesses in managing currency risk with FX hedging software, offering end-to-end solutions tailored to their hedging requirements.

Based in London, MillTechFX leverages the purchasing power of Millennium Global, one of the leading currency management firms. We provide a multi-bank FX execution platform for asset managers and corporates, offering access to competitive FX rates from up to 15 tier-one counterparty banks.

Our forex workflow, which includes quarterly transaction cost analysis to meet governance requirements, enables clients to optimise their FX operations whilst facilitating best execution.

To find out more about our FX hedging platform, get in touch here.

 

FAQ’s

Who is FX hedging used by?

FX hedging is used by a wide range of market participants from corporates to fund managers to help protect their business from currency volatility.

Can hedges be adjusted?

Fund managers and corporates can adjust the overall value of their hedges on the FX exposures.

In practice, this requires executing new forward trades for the same settlement date as the existing positions, to either increase or decrease the position size.

How much does FX hedging cost?

The cost of FX hedging can vary depending on various factors, including the type of hedging instrument used (such as FX forwards, options, or swaps), the currency pair being hedged, the duration of the hedge, and market conditions.

Usually, FX hedging costs can include transaction fees, the bid-ask spread, and any option premiums if option is used.

To discover the cost of hedging with MillTechFX and determine if you're overpaying, don't hesitate to contact us here.

 

Related terms:

• Currency Forward
• FX Options Market
• FX Risk Management