FX Hedging
FX hedging explained:
- What is FX hedging?
- FX hedging strategies
- Hedging FX risk
- What are the benefits of FX hedging?
- FAQ's
What is FX Hedging?
FX Hedging is a strategy used to help protect an existing or anticipated position from unwanted or negative moves in exchange rates.
FX hedging strategies
Forward hedging
Forward hedging is used for any future cashflow with a known value and known timing (e.g. monthly payroll).
When forecasting cashflow in different currencies, exchange rate movements can create uncertainty in what the final outcome will be. To gain certainty earlier in the process, firms can lock in the FX rate ahead of time.
Whilst they could use spot trades to exchange the currency before it is needed, that requires having the cash on hand to make settlement right away, typically within 2 days of trading.
A better tactic may be to use forward trades to lock in a rate for the required settlement date.
Rolling hedging
Long term investments with unknown timelines and values, often require a mechanism for hedging FX that doesn't rely on settling a specific amount (or even settling a trade in full at all).
In rolling hedging, futures contracts are opened for some period of time (often 1 or 3 months) and then closed a short time before they settle, by executing a trade in the opposite direction.
The overall approach is called rolling hedging, because when the fund closes their existing positions they will immediately open new ones for another month/quarter, an action known as rolling the positions so that the hedging is maintained throughout the whole period of time.
Hedging FX risk
- Margin Free hedging –FX hedging that doesn't require posting of margin or collateral
- Counterparty Risk Assessment Framework - Selecting and performing appropriate reviews on counterparties is an important part to
- Transaction Cost Analysis (TCA) – Highlighting hidden costs enables firms to understand the cost of their execution, as well as serving as an ongoing audit of FX execution costs
What are the benefits of FX hedging?
- Mitigates risks associated with FX exposure – reducing foreign exchange risks since the profits and losses arise from the FX hedging positions offset the foreign currency movements against the base currencies.
- Achieve cost savings – minimises costs and fees paid to third parties
- Provide certainty in forecasting cashflow – by securing an FX rate in advance
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 roll date.
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.
What is the difference between forward and rolling hedging?
The aim of forward hedging is to lock in a price when the notional of hedging amount and timing of the settlement is known.
Rolling hedging differs from simple outright forward hedging in that the rolling hedge aims to maintain the hedging positions of the currency exposures while the outright forward hedging is normally used to establish the hedging position at the inception.
Related terms:
What is MillTechFX?
We provide access to a transparent marketplace for comparative FX execution from up to 15+ counterparty banks, while harnessing a unique and significant pricing efficiency for our clients and reducing their operational burden. In addition, MillTechFX provides clients with full transparency of execution via independent TCA reporting.
