Hedging foreign exchange risk

What Does Foreign-Exchange Risk Mean?

1. The risk of an investment's value changing due to changes in currency exchange rates.
2. The risk that an investor will have to close out a long or short position in a foreign currency at a loss due to an adverse movement in exchange rates. Also known as
"currency risk"
or "exchange-rate risk"

Hedging transaction risk - the internal techniques
  • Invoice in home currency
  • Leading and Lagging: It refers to the adjustment of the times of payments that are made in foreign currencies. Leading is the payment of an obligation before due date while lagging is delaying the payment of an obligation past due date. The purpose of these techniques is for the company to take advantage of expected devaluation or revaluation of the appropriate currencies. Lead and lag payments are particularly useful when forward contracts are not possible.
  • Matching: When a company has receipts and payments in the same foreign currency due at the same time, it can simply match them against each other
  • Decide to do nothing.
Other techniques

Forward Contracts

A forward exchange contract (or forward contract) is a binding obligation to buy or sell a certain amount of foreign currency at a pre-agreed rate of exchange, on a certain future date. To take out a forward contract you need to advise us of the amount, the two currencies involved, the expiry date and whether you would like to buy or sell the currency. It can be possible to build in some flexibility to allow the purchase or sale of the currency between two pre-defined dates rather than a single maturity date.

Money Market Hedges
  • The idea is to avoid future exchange rate uncertainty by marking the exchange at today's spot rate instead.
  • This is achieved by borrowing / depositing the foreign currency until the actual commercial transaction cash flow occur.
  • In effect a foreign currency asset is set up to match against a future liability or vice versa

Future contracts

Foreign currency futures are exchange traded forward transactions with standard contract sizes and maturity dates — for example, $1000 for next November at an agreed rate. Futures are standardized and are usually traded on an exchange created for this purpose. The average contract length is roughly 3 months. Futures contracts are usually inclusive of any interest amounts.

Currency swaps

A currency swap is a foreign-exchange agreement between two parties to exchange aspects (namely the principal and/or interest payments) of a loan in one currency for equivalent aspects of an equal in net present value loan in another currency.

Currency swaps have two main uses:
  • To secure cheaper debt (by borrowing at the best available rate regardless of currency and then swapping for debt in desired currency using a back-to-back-loan).
  • To hedge against (reduce exposure to) exchange rate fluctuations

Currency option

A contract that grants the holder the right, but not the obligation, to buy or sell currency at a specified exchange rate during a specified period of time. For this right, a premium is paid to the broker, which will vary depending on the number of contracts purchased. Currency options are one of the best ways for corporations or individuals to hedge against adverse movements in exchange rates.

  1. Investopedia
  2. Angelfire
  3. HSBC
  4. Wikipedia
  5. Options
Further Reading
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