21 Jun Hedging Foreign Currency Risk
Are you concerned about your exposure to foreign currency risk? This blog discusses the different derivatives available to reduce the risk of adverse currency movements.
This is a bespoke contract to buy or sell foreign currency at a future date but at a fixed exchange rate. A forward contract will eliminate all downside risk and they are fairly easy to obtain.
These contracts are used to limit potential losses however this does also mean that no exchange gain would be made if the currency rates actually moved in your favour.
The other point to note is that everything about a forward contract is fixed being the date, the currency, the amount and the exchange rate. So if you find you no longer require it or want it for a different date, the original contract must still be adhered to.
Money Market Hedging
A money market hedge fixes the cost of a foreign payment by making a deposit in the spot market now; and fixes the revenue from a foreign receipt by borrowing in the spot market now. By depositing or borrowing prior to the payment or receipt, you are essentially fixing your own exchange rate.
This type of hedging may be useful if you are an importer with a cash surplus or an exporter with a cash shortage. However, money market hedges can be quite complicated and time-consuming to control so experience in this area would be advantageous.
Similar to the forward contract where the future date and exchange rate are fixed. However unlike the forward, futures contracts are standardised amounts so you may have to under or over hedge.
A futures contract would require an initial margin deposit and also maintenance margin deposits.
An option is the only derivative that gives you the right but not the obligation meaning if the markets move in your favour and you would have an exchange gain, you can decide not to exercise the option and take advantage of that gain.
This upside potential does come at a cost being a non-refundable premium, payable upfront whether or not you exercise the option.
A currency swap uses interest rates with cash flows in different currencies. So you would make a loan in one currency and receive a loan in another currency.
This type of hedge involves another party as you are ‘swapping’ interest rate payments over the life of the agreement. However you are still liable for the principle amount of debt you have borrowed and are therefore exposed to counterparty risk if the other party does not complete the interest swap payments.