Introduction: Understanding Hedging and Exchange Rate Risks
What is Hedging?
Hedging is a term that includes several risk management strategies that are used by businesses and investors. Generally, hedging involves offsetting a potential loss in one asset by taking a position in another asset with opposite or inverse performance.
Hedging protects against risks, but it also typically reduces potential gains. In other words, hedging generally limits losses but does not usually maximise profits.
Most hedging strategies involve assets that are negatively correlated. Though some assets can be expected to perform in opposite ways, businesses must use financial instruments and market strategies to determine which assets to make use of at any given time.
Businesses that engage in hedging may use a variety of assets, such as stocks, commodities, interest rates, and various other assets. For the purposes of this piece, we will consider foreign currencies and derivatives contracts such as options and futures.
Importance of Hedging
Hedging is important because forex markets are unpredictable, and foreign currency rates may fluctuate significantly and unexpectedly. Hedging protects against this risk.
In short, hedging can protect a business’s investments and holdings, provide a safety net, and make steady returns more likely. It can also create an allowance for riskier investments.
Despite those advantages, hedging has a few potential downsides. Hedging usually has costs because it necessitates working with additional assets. As such, businesses that engage in hedging should consider whether the cost of a hedge justifies possible gains.
It is also important to note that, although it provides some protection, hedging provides fewer guarantees than insurance. Though hedging mitigates risk and reduces losses, it carries risk in its own right and can impose greater costs on a company if it is done incorrectly.
Factors Influencing Exchange Rate Fluctuations
As noted, foreign currencies are constantly subject to exchange rate fluctuations. There are numerous factors that can cause these rate swings, including but not limited to:
- Inflation: Inflation occurs when prices rise within a country and the local currency loses buying power; this reduces the local currency’s exchange rate
- Interest rates: Governments and central banks can adjust interest rates, which may in turn attract foreign investment and raise the value of a country’s currency
- Government and public debt: Countries that have high debt ratings or rely on deficit financing may be less attractive to foreign investors; this can cause the value of a foreign currency to fluctuate and lose some of its value
- Political stability: Controversial political shifts, elections, and regime changes can reduce foreign investment, once again causing a currency to lose some of its value
- Economic recession: Recessions often cause holders of a country’s local currency to sell that currency, in turn reducing the value of the currency
- Government policies: Governments may set various policies, including trade policies, monetary policies (interest rates and circulating amounts), and fiscal policies (taxation and spending); these policies may affect a currency’s exchange rate
- Imports and exports: Countries with high export rates generally increase demand for their currency and raise the currency’s value; countries with high import rates generally reduce demand for their local currency and decrease the currency’s value
- Investor sentiment: Any event can cause forex investors and institutions to buy or sell a currency, leading that currency to fluctuate in value
- Stock markets: Publicly-traded companies in any given country can affect their local economy more broadly, causing the local currency to fluctuate
These are just a few examples of factors that can cause changes in exchange rates. Broadly speaking, any event that increases demand for a country’s local currency drives up the value of that currency. Any event that reduces demand for a local currency also reduces its value.
Performance is relative, so a local currency that is weakened against one foreign currency may remain strong against another foreign currency — and vice versa.
Types of Exchange Rate Risk
There are four main types of exchange rate risk: transaction risk, translation risk, economic risk, and jurisdiction risk. We’ll examine each type of risk below.
Transaction Risk
Transaction risks occur when businesses engage in foreign transactions. If a company makes a purchase in a foreign currency, and that foreign currency gains value before the transaction begins, the company will need to spend more of its local currency.
Conversely, if a company receives foreign currency for a sale, and that foreign currency loses value, the received amount will be less valuable after it is converted to a local currency.
Translation Risk
Translation risk occurs when a company operates in at least one foreign country and denominates its assets in the relevant foreign currencies. If those foreign currencies lose value, the company or its foreign subsidiaries will experience financial losses as well.
Because translation risk mainly concerns accounting and financial reporting, translation risks may not be actualised unless the company sells or makes use of the foreign assets in question — thereby turning translation risk into transaction risk.
Economic Risk
Economic risk (or operating exposure) includes indirect and long-term effects that may arise from currency fluctuations in general. Such trends may affect a company’s cash flows, earnings, and market value despite their broad nature.
For example, companies that do not operate internationally may be outperformed by competitors that are able to take advantage of beneficial exchange rates.
Jurisdiction Risk
Jurisdiction risk is a broader category that refers to risks that come from working in a foreign market, including but not limited to fluctuating exchange rates.
Apart from exchange rate risks, jurisdiction risk may also include risks related to basic business operations, legal and regulatory issues, and lending and borrowing. The category may include just about any risk related to a business’ foreign activities.
Hedging Techniques
Many techniques can be used to hedge against exchange rate fluctuations. In this section, we will examine five strategies that are commonly used as hedging techniques.
Forward Contracts
Forward contracts require an asset to be bought or sold on a specific date at an agreed-upon price. These contracts obligate two counterparties to complete a transaction.
Forward contracts involving foreign currencies protect against rate fluctuations. They generally are not intended for profit and accordingly prevent either party taking advantage of the other. However, there is a risk of either counterparty defaulting on the agreement.
Call and Put Options
Options are agreements that allow a transaction involving certain assets to take place on or before a certain date at an agreed-upon price.
Call options give a buyer the right to purchase an asset without being obligated to do so. Put options give a seller the right to sell an asset without being obligated to do so. Though one party is not obligated to complete the transaction, the other is forced to do so on request.
Like futures, foreign currency options eliminate certain risks around price fluctuations. Options also have low commitment requirements and are highly flexible. Unfortunately, options are quite complicated, and they carry risk in their own right.
Currency Swaps
Currency swaps are arrangements that involve two parties exchanging equal amounts of money denominated in different foreign currencies. This arrangement typically involves each party agreeing to repay the amount on a set date and at a set exchange rate.
This strategy is well-suited to parties that work extensively with foreign currencies. However, currency swaps may have high costs and limited liquidity, and there are counterparty risks insofar as one side of the arrangement might default on the agreement.
Money Market Hedges
Money market hedging occurs when a company locks the value of a foreign company’s currency in relation to its own local currency prior to a transaction.
This strategy avoids interest rate fluctuations altogether. It is also quite flexible, as it can be applied to just part of a transaction. Money market hedging is especially useful when companies must work with currencies to which few other strategies apply. However, money market hedging is generally more complicated than other alternatives.
Natural Hedging
Natural hedging occurs when a company receives funds in a foreign currency and continues to use the received currency for other parts of its operations. For example, an American company may receive euros for sales in the European market. It may then spend those euros to obtain goods in Europe instead of converting the euros to U.S. dollars.
This strategy does not require use of agreements or any complex financial products. However, it generally does not reduce risk as thoroughly as formal hedging strategies.
Selecting the Right Hedging Technique
There are numerous factors that your business should take into consideration when choosing a hedging strategy. You should carry out a cost-benefit analysis of each possible plan and align hedging strategies with your business’ goals and risk tolerance.
Different strategies carry different levels of risk and have different degrees of effectiveness, so it is important to select the appropriate strategy. You may want to seek advice from a financial expert in order to choose a hedging strategy that is right for your business.
Implementing a Hedging Program
There are several steps that a company should take to implement a hedging program. Chatham Financial describes ten steps that businesses should take, summarised here.
- Determine your hedging objectives and success metrics
- Measure risk and decide on risk tolerance
- Determine a hedging strategy
- Find out how hedging will impact your treasury
- Create a return-on-investment (ROI) strategy
- Create a governance structure to oversee the hedging program
- Identify key performance indicators (KPIs) and create a monitoring program
- Create a roadmap for your hedging program
- Produce documentation that serves as a strategy playbook
- Outline a change management plan and communicate with others
It’s important to involve stakeholders and provide insights into how your strategy is monitored and adjusted. This will ensure that your business maintains trust and transparency.
Case Studies
Hedging strategies are extremely common in the business world. Below, we’ll take a look at two examples of foreign exchange hedging strategies used by real-world companies.
First American Bank
First American Bank provides a case study of one of its clients — an American construction company that used foreign exchange hedging to prearrange a large transaction.
The U.S.-based construction company arranged a six-month FX forward with First American Bank. This allowed the construction company to obtain a locked-in price for a piece of German machinery that had a six-month delivery time and an initial 50% down payment.
The construction company’s hedging strategy helped it avoid fluctuations in the EUR/USD exchange rate in the time between the initial request and the final transaction.
First American Bank noted that this sort of strategy is ideal for companies that do business internationally. It added that bank advisors can help businesses find other opportunities.
BMW Group
Another case study, described by the Financial Times, explains how the automotive giant BMW Group used two hedging strategies to manage its foreign exchange exposure.
First, BMW used a natural hedging strategy to spend money without converting it away from the foreign currencies that it gained through sales. Second, it used formal hedging strategies by setting up regional treasury centres in the U.S., UK, and Singapore. Those centres were responsible for reviewing exchange rate exposure and recommending actions.
Both strategies helped BMW reduce foreign exchange exposure. Critically, these strategies meant that exchange rate exposure was not passed onto users through higher prices.
Conclusion
Hedging is an important strategy for any business that is involved in foreign currency transactions or investments. Because foreign exchange rates fluctuate rapidly, hedging strategies can protect against loss and help your business avoid volatility.
There are multiple hedging strategies, and not every strategy is appropriate in every situation. You should always rely on experts when making important financial decisions.
