Tips on How To Hedge Against Currency Risk
Currency risk affects every business that operates internationally. So, if you run a global business or an investment that requires you to exchange currencies, an exchange rate risk should be one of your top concerns. Failure to manage the risks can cause losses.
Due to currency volatility, many international businesses are exposed to currency risk, with or without their knowledge. For example, when the value of a local currency falls, it can buy less of a more robust foreign currency. So, its purchasing power decreases.
Despite the volatility of currencies and exposure to currency exchange risks, businesses can still protect themselves from losses by hedging the risks. Thankfully, there are many ways to manage or hedge currency risks. Keep reading to learn the hedging strategies.
Why You Need to Hedge Against Currency Risk
Foreign exchange risks can result in significant losses when unhedged. According to a survey done by HSBC, 70 percent of chief financial officers said that their companies suffered reduced profits in the previous two years due to avoidable, unhedged FX risk.
Based on the HSBC report, small or big businesses need to protect themselves against exchange risks. But, unfortunately, small and mid-sized companies tend to underrate their exposure to currency risks due to the lack of know-how and time.
Here are some of the benefits of managing currency risks in small and large companies.
- Improves financial budgeting and forecasting
- Increases businesses’ borrowing capacity
- Protects cash flow and profit margins in businesses
- It helps companies understand how currency fluctuations affect balance sheets
Different Types of Currency Risks
Essentially, there are three different types of currency risks facing companies that operate internationally. They include transaction, translation, and economic risks.
This type of risk can affect a company that buys products from another company in a foreign country. So, the company selling the item will denominate the price in its country’s currency. As a result, if the seller’s currency was to appreciate against the buyer’s, the buyer will have to pay more for the product.
If a company owns a subsidiary branch in another country, it will likely face translation risks. Since the subsidiary’s financial statements might be denominated in the host country’s currency, the parent company will have to translate back the currency for reporting purposes. That could result in losses.
This type of risk can result from unforeseen and unavoidable currency exchange fluctuations. As a result, it can affect a company’s future market value and cash flows. The bad news is that an economic risk can be long-term in nature and affect long-term strategic decisions.
Ways on How to Hedge Currency Risk to Protect Your Business
Now that you know the benefits of foreign exchange risk management, you may wonder where to start. There are many ways to hedge exchange risks, including simple and complicated ones. The most popular option is the currency forward contract.
The other tools for hedging currency risks include:
- Futures contracts
- Contract for Difference (CFDs)
- Specialized Exchange Traded Funds (ETFs)
Now, let’s gain more insights into the four different tools for hedging currency risks.
Hedging Currency Risks with Forward Contracts
A forward contract is the most commonly used tool to hedge currency risks. It allows an investor to lock in an exchange rate for a specific amount for use at a particular future date. In other words, they agree to sell or buy a currency at a fixed rate at a future date.
A forward contract between two parties is not tradeable. So, when the parties close deals and plan at specific rates, they incur no cost. However, there’s usually the risk of one party not complying. So, if a party defaults, the other party may get inconvenienced.
The benefit of a forward contract is that it can protect your assets from exchange rate fluctuations by locking in a specific value.
Here is an example of how a forward contract works.
Suppose a Chinese company agrees to ship electronics to a Canadian buyer for 12 months. The two parties can sign a forward contract stating that the Canadian will make payment at the end of 12 months using today’s CAD/CNY exchange rate.
Whether the exchange rates fluctuate or not, the Canadian buyer will still pay the same amount of Canadian dollars he would have paid today.
Hedging Currency Risks with Futures Contracts
Futures contracts are agreements between parties to buy products or currencies at a specific price on a specific date. They give conditions for currency exchange, including the exchange rate, amount, and expiry date. Thankfully, they’re less risky hedging tools.
The future contracts are readily available on the market, and investors can trade them like other financial assets. While the tools work more similarly to the forward contracts, they remove the non-compliance risks of forwards, making them more reliable.
Unfortunately, futures are non-customizable are often available in major currencies such as the U.S. dollar and British pound.
Hedging Currency Risks with CFDs
You can use a contract for difference (CFD) to hedge foreign exchange risk. Thankfully, you don’t need to own the underlying currency to use this hedging tool.
So, how does the CFD work?
When you opt for a CFD, you agree to exchange the difference in an asset’s price (currency) from when the position gets opened to when it gets closed.
If the market shifts in the direction you predicted, you win. But if it moves against your prediction, you lose. The good news is that you can use CFDs to hedge currency risks. But since they are leveraged instruments, you need a small amount of capital to hedge.
Hedging Currency Risks with Specialized ETFs
Investing in a specialized ETF can help you hedge a foreign exchange risk. It functions like any other exchange-traded fund, but it uses currency cash deposits instead of holding bonds and stocks. It can also hold the derivatives of the underlying currency.
The instruments tied to the underlying currency will replicate the currency’s movement in the exchange market. Also, hedging currency risks with a specialized ETF requires little management fees. That is because the funds’ management requires little effort.
Tips and Ideas on How to Hedge Against Currency Risk
Now that you know a few tools that can help you hedge against currency risks, you can start by analyzing your business’s cash flow. The following tips and ideas will help you.
- Review your company’s operating cycle to determine how sensitive your profit margin is to currency fluctuations.
- Establish the FX rules you intend to apply to your currency risk management and stick to them
- Manage your exposure to foreign exchange risks, especially when dealing with physical products
- Automate foreign exchange handling to make your work easier
- Pick economically sound countries with strong, rising currencies
- Invest in hedged mutual funds and exchange-traded funds (ETFs)
- Diversify your investments in several foreign securities
Currency risks can result in losses, especially when the volatility is very high. So when investing in international markets, you should manage your exposure to the risks. Invest in currency hedging tools like forwards and futures contracts to protect yourself against the risks. However, some of these currency hedging tools can result in extra costs.