If You Aren’t Hedging Exchange Risk, It May Be Time to Rethink Your Strategy

If You Aren’t Hedging Exchange Risk, It May Be Time to Rethink Your Strategy

Author: Kalli Heupel, Director, Foreign Exchange

Uncertainty is always a factor when trading in foreign markets. Currency fluctuations are common and unpredictable, putting companies at risk when transacting in foreign currencies. Fortunately, there are several ways to bring more certainty to the process by hedging exchange risk.

Below, we discuss the most common instruments and how they may help you reduce your exposure during foreign trade transactions.

Why Trade in Foreign Currencies

As companies negotiate international contracts, it may seem most favorable to conduct business in your home currency. However, there are some drawbacks to this approach.

When transacting in home currencies, businesses pass the risk to their suppliers, many of whom will levy additional costs to cover the risk they face. For example, it is common for suppliers in Mexico to account for market fluctuations by marking up the price of goods as exchange rates become less favorable.

In this situation, paying in the foreign currency makes it possible for companies to negotiate with suppliers in the country where they are doing business, which may drive down the costs associated for all.

There may also be advantages for a company to price their foreign customers in the customer’s local currency.  The sales price could be easily measured against local competitors since foreign customers can weigh their options with an apples to apples price comparison. 

However, the company also assumes risk when conducting business in a foreign currency. Most of the risk involves fluctuating exchange rates. A contract negotiated at $1 million, for example, could end up returning less if the exchange rate changes unfavorably.

To protect profitability, companies may use some form of hedging, using financial instruments to reduce the associated risks.

Understanding Hedging Instruments

When it comes to international trade, there are several ways to hedge exchange risk, and the advantages differ depending on the needs of the business.  Hedging offers a multitude of benefits to the companies that utilize them, including the ability to offer predictable cash flows, the ability to lock in profit margins and most importantly, risk reduction.

Spot Contract

A spot contract allows a company to purchase currency now for payment to be made usually one to two days in the future. In this scenario, the business benefits from a simple exchange of currency at the prevailing exchange rate.

Spot contracts are particularly beneficial if a company needs to make an immediate payment, which is typically done via wire transfer. Initiating a spot transaction is simple and can even be completed under existing agreements with your local financial institution.

However, a spot contract can be risky at times, as it does not protect the company against long-term currency fluctuations from when a transaction is agreed upon to when funds are sent.

Forward/Window Forwards

A forward contract allows a company to lock in an exchange rate now for settlement on a specified future date. This contract is purchased through a third party, usually a bank, locking in the rate at the time of the sale. Currency doesn’t change hands until the value date or the end of the contract.

Companies benefit by knowing exactly how much they will pay or receive from a transaction. However, a forward is a contractual obligation, so if the contract ends up not being needed, the company will have to liquidate at the current market and realize the gain or loss depending on which way the currency moved. 

Non-Deliverable Forward

Non-deliverable forwards are used in situations where there is no active forward market to provide protection against adverse currency movements during the term of the contract. A non-deliverable forward is like the forward contract in that an exchange rate is agreed upon ahead of time for a future date. However, instead of purchasing currency on a set date, both parties agree to settle the difference between the rate established at the contract’s inception and the effective spot rate on the fixing date.

Countries where a non-deliverable forward may be utilized include Brazil, Taiwan, South Korea, and China. It’s important to note that a non-deliverable forward does not provide protection against adverse currency movements at the time the difference is paid.

Currency Option

Lastly, a currency option allows a company to buy or sell currency at a specific rate on or before a specified date but does not obligate them to do so. This type of hedging instrument provides the company with flexibility and the potential for unlimited upside on its exposure but may require an upfront cost. If the spot rate in effect on the contract’s settlement date is more favorable, then the business can choose not to exercise the option’s exchange rate and buy or sell at the current market rates.

Keep in mind, a currency option may require a payment of an upfront premium that will need to be taken into consideration when determining the underlying exposure.