Effective hedging strategies: mitigating foreign exchange risk

As currency rates fluctuate daily based on supply and demand, so too does an international company's foreign exchange exposure. A major risk associated with foreign trade is foreign currency fluctuations. Currency risk, or exchange currency risk, refers to the losses that an international financial transaction can incur due to currency fluctuations and the risk arises due to a variation in the relative valuation of one currency against another. Variations can have a negative effect on an investment’s overall returns and create losses for a company. Being by nature international, the travel sector is highly exposed to currency fluctuations for example.

Tackling currency risk

For companies exporting goods and services internationally or sourcing from abroad, currency fluctuations must seriously be taken into account. Small and medium businesses in particular fall prey to such currency risk. Although most SMEs view currency risk as one of the most significant challenges in conducting international business, very few have put in place risk management systems to monitor and alleviate their exposure to currency risk. However, a range of solutions exist to protect against foreign exchange market volatility.

With all sorts of global events shaking the world and deeply affecting international trade, from Brexit and turbulent US elections to the coronavirus pandemic, the war in Ukraine and inflation, most companies are well-aware of the need to prepare for a wide range of risks. Yet so few are sufficiently equipped to deal with avoidable FX risk. A 2020 Nordea survey of SMEs in Nordic countries indicated that lack of time and know-how were the two main factors that prevented many SMEs from being able to manage their currency risk.

Types of foreign exchange risk

Currency fluctuations can impact a company’s cash flow on various levels. Many factors contribute to determining how currency rates can affect a business’ cash flows. Starts with knowing where and how currency fluctuations affect a company’s cash flows.

Portfolio risk

Also known as translation risk, the portfolio risk inevitably arises when a company has business operations overseas and it has to translate a subsidiary’s financial statements to its parent company’s home currency as part of its reporting. This type of currency risk occurs if a company reports a consolidated financial statement for its subsidiaries and concerns intercompany accounting. While portfolio risk in itself rarely causes financial distress for a company, it can have seriously negative knock-on effects, leading to a poor quarterly performance and depressing the company’s market share price for example.

Economic (or operating) risk

This type of long-term risk refers to situations when a company’s market value and/or future cash flows are impacted by exposure to currency fluctuations. Also called forecast risk or operating exposure, this type of risk occurs when a foreign competitor selling to the same customer as the company has a more favorable exchange rate. As a result, the company would lose value through no fault of its own.

Transaction risk

This risk is often the most visible currency risk a company faces. It is also the easiest risk to measure and manage. This type of risk arises because of the time difference between the moment the company enters into a contract and the moment it receives payment, which usually happens after a delay that can go up to 120 days. During this period between the sale and the receipt of funds, the fluctuating value of a currency may leave a company exposed. These types of currency risk generally affect short-term, foreseeable cash flows making them easily definable and manageable.

Companies operating internationally are particularly susceptible to this range of currency risks. And while not all these risks can and should be managed, facilitating planning, enhancing performance management and tax purposes are all valid reasons to look into managing currency risk. However, those risks that can be managed, such as transaction risks, can strongly benefits from hedging strategies.

Managing currency risks through hedging

While foreign exchange risk is an inevitable reality for companies trading in international markets, hedging can help mitigate the risk. Hedging is a strategy that aims to limit risks in financial assets by adopting an opposite position in a related asset. It is important to keep in mind that hedging strategies are not intended to generate profit but rather to reduce or, at best, eliminate losses and the risk of uncertainty. In an effort to fence-off risk and control its outcome, hedging operates as an insurance. The most common way to hedge foreign exchange exposure is through the use of hedging strategies that rely on financial instruments.

Hedging strategies

Forex hedging aims to reduce and limit exposure to fluctuations on the foreign exchange market including fluctuations related to exchange rates, interest rates and other unexpected changes in the foreign currency market. The two most common methods to hedge foreign currency exposure are forward contracts and currency options. Forward contracts and options are a form of derivatives, namely over-the-counter derivatives, meaning that they are not traded on centralized markets but rather privately negotiated between two counterparts.

When it comes to hedging, the terms “short positions” and “long positions” come up frequently and it is important to understand what they refer to. A long position, or “going long”, refers to buying a currency against another one and implies aiming to make a profit based on the expectation that the price will increase. A short position, or “going short”, on the other hand refers to selling a currency against another one and is intended to protect the seller by locking in the sale price. It implies making a profit when the price decreases.

Forward contracts

Forward contracts, or forward exchange contracts, are agreements whereby a business accepts to buy or sell a specific amount of a future currency on a specific future date. This solution enables the business to protect itself against any fluctuations that may occur until this specific date. More specifically, forward contracts can take the form of flexible forward contracts as well as dynamic forward contracts.

Options

Like forward contracts, options are a form of derivative products. However, their difference lies in the fact that they give the counterparts the right but not the obligation to buy or sell a currency pair at a specific price on a specific date in the future. These are so-called call options and put options.

While a call option gives the holder the right to buy a currency pair, a put option gives the holder the right to sell a currency pair. These options are called traditional call or put options and are often referred to as “vanilla”. They come in the form of long or short put or call options and tend to be used as part of short-term hedging strategies. They have the added advantage of being flexible in form, protecting holders from unexpected downturns in the market, and enabling them to retain profit possibilities.

A SPOT option, or single payment option trading, on the other hand, is more flexible as it allows the holder to choose the payout and to set certain market conditions to receive this payout. These conditions come with a purchasing cost, known as the premium. If the conditions are met, the holder receives a profit. If they are not however, the holder must forfeit the premium. SPOT options, also called binary options, carry a risk of loss which is why most forex brokers do not sell such contracts without substantial protection.

On the options market, it is possible to calculate the sensitivity to risk of a particular type of trade by measuring the relationship between the option and a quantifiable variable. Various Greek letters are used to represent these variables and they are commonly referred to as the “Greeks”. Each variable is assigned a number giving traders more information as to the degree of risk related to the option. These numbers are not set in stone and can freely evolve over time depending on the situation of the option in question. There are many variables that can be used to assess risk parameters, but the main ones used in the options market are the following:

• Delta - It represents the rate of change between the price of the option and a change of $1 in the price of the underlying asset.
• Gamma - It refers to the rate of change between the delta of an option and the price of the underlying asset.
• Vega - It measures the change in the option price with respect to a unitary change in the implied volatility. 
• Theta - It refers to time sensitivity and represents the rate of change on the option price in time.
• Rho - It measures the change in the option price with respect to a unitary change in the interest rates.

Finding the right hedging strategy

For companies engaged in international trade and exposed to currency fluctuations in their everyday business, adopting foreign exchange hedging strategies can help manage and mitigate currency volatility and reduce uncertainty on the bottom line. While exploring possibilities to implement these strategies should play a critical part in a company’s risk management solution, understanding what the most effective hedging strategies for a given company are can be tricky. At iBanFirst, our experts know all about hedging solutions for international companies and are there to help you use currency fluctuations to your company’s advantage. Contact us to find out how hedging strategies can help your company weather currency volatility. 

Back to the top ↑