FX Hedging

 

Summary:

• FX hedging is a risk management used to safeguard financial positions against adverse fluctuations in exchange rates due to 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 can be defined as a risk management strategy undertaken by businesses and investors to safeguard their financial positions against adverse fluctuations in exchange rates due to currency volatility.

By hedging FX risk, asset managers and corporates can reduce the effects of unpredictable currency movements arising from international investments, ensuring greater financial stability and predictability. This is crucial in today's global economy, where currency values are affected by various factors such as economic data releases, geopolitical events, and shifts in monetary policy.

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?

Hedging FX works by using financial instruments or strategies to reduce FX risk. Businesses and investors employ different hedging techniques to secure exchange rates for future transactions, protecting 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:

FX forwards are over-the-counter (OTC) derivatives, meaning they are traded directly between two counterparties and can therefore be highly customised to suit the bespoke hedging requirements of the clients.

In FX, this involves a currency forward contract to buy or sell a set amount of an asset on a future date at a price determined today.

By securing a forward price, the trade is protected from currency volatility, effectively hedging FX risk with FX forwards contracts.

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

FX hedging software can help businesses and investors to simplify their FX processes and secure best execution on every trade.

MillTechFX, an FXaaS company based in London, delivers comprehensive FX hedging solutions to assist businesses and investors in managing their hedging requirements whilst achieving best execution.

Harnessing the purchasing power of Millenium Global, one of the largest currency management groups, we are offering a multi-bank FX execution platform for asset managers and corporates, granting them access to competitive FX rates from up to 15 tier one counterparty banks.

Through our end-to-end workflow, including quarterly transaction cost analysis to meet governance expectations, our clients are able to streamline their FX operations whilst achieving best execution outcome on overall FX 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