FX Hedging

FX hedging is the practice of protecting against losses caused by changes in exchange rates. A company, investor or financial institution that expects to receive or pay money in a foreign currency, or that holds assets abroad, takes an offsetting position so that a fall in one is matched by a gain in the other. The aim is certainty about future values in the home currency, not profit from currency movements.

Hedging is the main tool for managing foreign exchange risk. It is used by importers and exporters, multinational groups, fund managers with foreign holdings, and payment companies that quote customers a rate before they have converted the money. It can be done with financial instruments bought from banks or with changes to how the business itself operates.

The starting point is to identify the currency exposure. Transaction exposure arises from specific payables and receivables: an invoice issued in dollars by a company that reports in euros. Forecast exposure comes from sales or purchases that are expected but not yet contracted. Translation exposure is the effect of exchange rates on the reported value of foreign subsidiaries. Most corporate hedging addresses the first two, since they affect cash.

Before using any instrument, treasurers reduce the exposure where they can. Offsetting receipts and payments in the same currency across the group, described under foreign exchange exposure netting, leaves only the net amount to cover.

• Forward contracts. An FX forward contract fixes today the rate at which two currencies will be exchanged on a future date. It is the most widely used hedge because it is simple and has no upfront premium.
• Non-deliverable forwards. For currencies that cannot be freely delivered offshore, a non-deliverable forward settles the difference between the agreed rate and the market rate in a major currency.
• Swaps. An FX swap combines a spot exchange with a forward in the opposite direction and is used to roll a hedge or to shift its date. Longer-dated currency swaps hedge foreign currency borrowing.
• Options. An FX option gives the right, but not the obligation, to exchange at a set rate. The holder is protected against an adverse move and still benefits from a favourable one, in return for a premium. Combinations such as collars reduce the premium by giving up part of the upside.
• Natural hedges. A natural hedge matches costs and revenues in the same currency, for example by sourcing supplies or borrowing in the currency of sales.

A German manufacturer sells equipment to an American customer for 1,000,000 dollars, payable in three months. At today's spot rate of 1.10 dollars per euro the sale is worth about 909,000 euros. If the dollar weakens to 1.20 by the payment date, the same dollars will fetch only about 833,000 euros.

To remove the uncertainty, the manufacturer sells 1,000,000 dollars forward for three months at a forward exchange rate of, say, 1.105. Whatever happens to the market, it will receive about 905,000 euros. The forward rate differs from the spot rate by an amount that reflects the interest rate differential between the two currencies, not a forecast. The cost of the hedge is that the company gives up any gain if the dollar strengthens instead.

Companies set rules for how much to hedge and how far ahead. The proportion of an exposure that is covered is the hedge ratio. Firm commitments are often hedged in full, while forecast flows are hedged in declining proportions the further out they lie, because forecasts may prove wrong.

Accounting influences these choices. Derivatives are carried at fair value, and without special treatment their gains and losses would reach the income statement at different times from the transactions they protect. Hedge accounting allows the two to be matched if the relationship is documented and shown to be effective.

Cross-border payment and remittance companies carry currency risk whenever there is a gap between the rate promised to a customer and the rate at which the firm itself converts. Those that guarantee a rate for hours or days, or that hold balances with payout partners in volatile currencies, hedge the resulting positions or keep them small by converting quickly. Some use just-in-time FX, buying currency only at the moment of each payout, so that little exposure builds up. Platforms that let merchants price in one currency and settle in another face the same question across the period between sale and settlement.

Hedging has direct costs, in the bank's spread or an option premium, and indirect ones. Forwards and swaps create obligations to the bank, which may require credit lines or collateral, and a large adverse move in the hedge's market value can produce a margin call that strains liquidity before the underlying cash arrives. The bank on the other side is a source of counterparty risk.

A hedge of a forecast that fails to materialize becomes a speculative position. Hedging also only defers the effect of a lasting change in exchange rates: once existing contracts expire, new ones are struck at the new level. For these reasons hedging is treated as a way to gain time and predictability, not as a means of eliminating currency risk altogether.