Foreign exchange hedging for businesses: Your questions answered
What is foreign exchange hedging?
Foreign exchange hedging is used by businesses to manage their currency exposure. If a business needs to buy or sell one currency for another, they are exposed to fluctuations in the foreign exchange market that could affect their costs (or revenues) and ultimately their profit.
By booking a hedge, businesses protect an exchange rate against a specified sum for a desired timescale, providing businesses with certainty.
There are different hedging strategies and range of products that can be used and it all depends on the businesses objective and the exposure they are trying to protect.
Why would a business choose to hedge their foreign exchange?
A business would hedge their FX exposure to protect its profit margin from market volatility. It is most common in businesses that have an exposure to a secondary currency and have fixed prices on their products or services.
When would a business not hedge foreign currency?
A business may decide not to hedge if they do not have enough visibility to forecast their currency requirements. Alternatively, a business may have the ability to reflect the market movement in their pricing, whereby they pass on any currency risk to the customer or supplier.
What is a foreign exchange natural hedge?
A natural hedge is where a business both receives and pays in a currency which is not their domestic currency. Thus the exposure offsets. However, a natural hedge may not be “perfect” if the timing of the currency doesn’t match up. If a natural hedge is not “perfect”, a currency specialist can help you bridge the gap
When are FX forward contracts used by businesses?
A forward contract can be used to protect a business against volatility within the currency rate.
If a UK exporter sells its products overseas, a forward contract can be put in place to guarantee a rate to repatriate the revenue in to Sterling, mitigating foreign exchange volatility.
Alternatively, a UK importer may agree a 12-month contract with an overseas supplier which will be paid in a foreign currency. By fixing the exchange rate for this contract period, a forward contract will prevent foreign exchange fluctuations from impacting the costs of the contract.
What is a closed forward contract?
A closed forward contract allows the business to buy or sell a pre-determined sum of currency on a fixed date in the future.
ABC Ltd agrees to buy EUR €120,000 for GBP at a rate of 1.20. The value date is set for July 31st 2019. On the maturity date ABC Ltd sends their counterparty £100,000 and €120,000 is sent to business ABC Ltd EUR account or to a third party.
What is an open forward contract?
An open forward contract gives the business flexibility to exchange currency at any time within the contract period up to the value date.
ABC Ltd agrees to buy USD $135,000 for GBP at a rate of 1.35. The value date is set for December 31st 2019. Company ABC decides to draw down from the contract 3 times during the contract period $35,000, $50,000 and $50,000. Each time company ABC Ltd draws down from the contract they send their counterparty the equivalent value in GBP at the agreed exchange rate and the USD are placed in company ABC Ltd USD account or sent to a third party.
What is the maximum duration of an FX forward contract?
Typically, the maximum length of a forward contract available to businesses is 24 months.
Are there any cash implications when booking a forward?
Some providers will ask you to pay a deposit to secure the forward contract which will be returned at the end of the contract. This is typically around 5% of the value of the contract.
Margin call is also included in the terms of the forward contract. Additional deposits could be called upon during the contract period should the market move outside the credit terms agreed, which leaves the original deposit no longer covering the potential liability.
Note: This is only additional deposit, if the market moves back to a favourable position then the funds are returned back to the business before the maturity date. If not, the funds will be returned at the end of the contract.
What other hedging products exist?
Structured hedges are a group of financial instruments that, generally speaking, function similar to a forward contract, in so far as it will protect against adverse rate movements. However structured hedge also tend to offer potential level of rate improvement, or rebate, should the market be more favourable on the expiry date.
As such, businesses with large and forecastable currency exposures, which use forward contracts, will often blend some structured hedges into their portfolio of currency protection.