Reduce Exposure to Foreign Exchange Risk by Using a Hedging Strategy

If your business or investments rely on moving money from one currency to another you'll be aware that fluctuations in the exchange rate can cause havoc with cash flows and planning. Because of this, risk management experts use hedging techniques to reduce the uncertainty associated with foreign exchange, allowing them to plan ahead with greater certainty.

Just as there are economic risks, there is always a risk of foreign exchange exposure - after all price movements in the Forex markets are driven by a host of real world variables and many of them are unpredictable. It makes sense to manage and mitigate these risks by setting up a hedge that gives you greater control over these foreign currency movements.

WHAT EXACTLY IS FOREIGN EXCHANGE RISK?

Foreign exchange risk is a type of financial risk present when a monetary transaction is denominated in a currency other than the domestic currency. An exchange risk arises when there is the danger of an unfavourable movement in exchange rates between the domestic currency and the denominated currency before the date when the transaction is completed. Foreign exchange risk can be mitigated by using a financial product known as a hedge.

Companies or investors which rely on exporting or importing goods and services, or making foreign investments, have an exchange rate exposure which should ideally be managed in a way that reduces the risk of unfavourable exchange rate movements.

As we all know, this type of exchange rate risk is a fact of life when it comes to the currency markets, but with a few simple steps you can protect your cash flows and profits and enjoy the peace of mind that comes when you don't have to worry about a fluctuation in rates.

WHO CAN BENEFIT FROM USING A FOREIGN EXCHANGE HEDGE?

Simply put, any business or individual who relies on transferring funds from one currency to another should consider setting up a hedging strategy. Imagine a UK business that ships beauty products to the EU. At a certain point, the business will want to repatriate profits in the foreign currency from the EU to the UK - that is, they will want to sell Euros and buy Pounds.

If, due to currency fluctuations over the sales period, the value of the Euro has depreciated against the Pound, the company will have lost out and its cash flow will have been impacted. On the other hand, if it had adopted a hedging strategy it will have likely secured its profits rather than lost out. This Forex risk is unacceptable and yet it is easily avoided. There are numerous tools available to minimise risk and reduce exposure - some simple, some more complex. Below we will look at a few of the more common FX risk management options available.

COMMON FX RISK MANAGEMENT TOOLS TO HELP REDUCE CURRENCY EXPOSURE

A popular hedging tool used for securing an agreed-upon exchange rate is a forward contract. This allows for a certain exchange rate to be set for a certain point in the future, giving a degree of security. However, while forward contracts guard against spot rate volatility they are one of the less flexible FX trading instruments and require rolling over at the end of each time period. In the same class as a forward, a stop loss order is similar in that the buyer sets a lower exchange rate boundary with the FX broker. This is often used for situations when an exchange rate is fast devaluing as it gives a degree of certainty that further losses will be minimised. Related to this is a one-cancels-the-other - or OCO - which is a combination of a limit order and a stop loss order.

CURRENCY RISK: KNOW YOUR OPTIONS

The most flexible and popular tools employed to guard against FX risk are vanilla options. As with options on other types of investments, foreign currency options give the purchaser the right - but not the obligation - to buy or sell the currency pair at a particular exchange rate at some point in the future.

The main reason vanilla options are so popular is that they take the risk out of currency exchange, usually for a competitive fee. They are far more flexible than any of the other widely used hedging instruments as they offer security without the obligation to call on the contract. If, for example, the buyer doesn't need to call on the option because the exchange rate has risen, then profit will already have been secured and the option fee will be deducted.

HOW TO REDUCE RISK USING A CURRENCY HEDGE

By signing up with a currency provider such as Currency Solutions you can take advantage of FX hedging options. If you are a business owner or a corporate investor dealing in foreign markets and local currency, ask about your options for reducing risk and securing an exchange rate that works for you. Perhaps you have finance investments in foreign equities, or maybe your company has sold product in overseas markets and you are looking to repatriate the profits - whatever challenge you face you can be sure to manage the risk of volatile currency markets by using an FX hedge.

MANAGE YOUR FOREIGN EXCHANGE EXPOSURE

Anyone who is concerned about their exposure to the volatility of the currency markets can benefit from developing a hedging strategy as part of a wider risk management policy.

To find out more about your day-to-day exchange rate risk and how to hedge against it contact Currency Solutions today and we'll talk you through your options.