Exchange Rate Hedge

Foreign exchange (“forex”) hedging is a strategy used to reduce the risk of a change in forex rates negatively impacting expected revenue or an expected payment. For large sums of money, even a nominal change in the exchange rate, can severally impact the final value of the transaction.

It may help to think of a hedge as a form of insurance that protects you from a certain event, and like most forms of insurance, it does cost you something up-front to “purchase” the insurance. Also, the hedge insurance may not be able to provide 100% protection, but with careful planning, you can minimize capital losses resulting from exchange rate fluctuations.

Because there is a cost to formulate and put a forex hedging strategy in place, you must be sure that the cost is justified given the potential losses. In some cases, it may be a better option to forgo the idea of a hedge altogether.

The purpose of a forex hedge is to minimize the risk you face with a known forex rate exposure. You should consider the necessity of creating a hedge to protect against future exchange rate fluctuations whenever you expect to deliver or receive payment sometime in the future that involves a conversion of currencies. We will look at these three common hedging approaches:

• Exchange Rate Forward Agreements
• Currency Futures
• Currency Market Spot Trades to Offset Forex Rate Exposures

Exchange Rate Forward Agreements

An Exchange Rate Forward is similar to a Forward Rate Agreement (FRA) commonly used to hedge against fluctuations in interest rates, and consists of an agreement whereby two parties agree to a foreign currency transaction at the current exchange rate, but with payment and delivery to be completed at a specified date in the future. Note that the exchange rate at the time the agreement matures has no bearing on the transaction – the valid exchange rate is the rate specified at the time the agreement is originally implemented.

An Exchange Rate Forward offers effective protection from interest rate fluctuations provided you can find someone to agree to enter into a contract with you. After all, if you feel it is likely that the USD will continue to weaken against the British Pound for instance, and are looking to protect yourself against such an event, it may prove difficult to find a counterparty who believes the opposite and is willing to accept terms that adequately address your exposure.

Currency Futures

A currency futures contract is structured similarly to an Exchange Rate Forward, with each currency future consisting of a currency pair and an expiry date. Currency futures contracts are valued each day (i.e. marked to market) by means of a valuation formula that considers the interest rates for the currency pair, the current spot rate, as well as the time remaining to the expiry date. A recognized exchange then prices the contract and provides a market for the buying and selling of currency futures.

The first currency futures market was established by the Chicago Mercantile Exchange (CME) in 1972 and consisted of only seven currency pairs. Today, the CME offers more than forty currency futures combinations with over $80 billion transacted each day.^[2] Paris-based EuroNext and the Tokyo Stock Exchange also provide very active currency futures markets.

Hedging with Currency Futures

As an exchange rate hedge, you simply buy and hold the futures contract until expiry. For instance, consider 123 Corp – a US-based company – which expects to receive a $5 million payment through its Canadian subsidiary in six months. This money must then be converted to U.S. dollars when recorded into the company’s books.

This causes senior management at 123 Corp some concern however, as there are fears that the U.S. dollar may continue to weaken over the next few months, resulting in a lower amount when converted to USD six months from now. To protect from future losses tied to exchange rate fluctuations, 123 Corp decides to turn to the currency futures market to buy a contract suitable for hedging purposes.

A USD / CAD futures contract is identified that offers an exchange rate of 1.01084 and expires in six months. Therefore, in order to lock in this forward rate, 123 Corp would sell (i.e. short) $5 million CAD worth of futures contracts – then, when 123 Corp receives payment from its Canadian subsidiary, it can use those funds to provide payment for the contract which is also due, thus ensuring an effective exchange rate of 1.01084 for the $5 million Canadian dollars.

If 123 Corp had failed to hedge this payment and the exchange rate decreased by just 3% for example, 123 Corp would have lost over $144,000 USD. Review the following table where the first line calculates the USD amount booked at the hedged rate, while the second line shows the USD amount if 123 Corp had not locked in the exchange rate using a currency future:

Speculating with Currency Futures

Because there is an established currency futures contract market and a large pool of traders and investors dealing in currency futures, these derivatives are often used as speculative instruments. This is due to the fact that the contracts are valued each day resulting in an arbitrage opportunity whereby a speculator may hope to profit on changes in the contract prices.

For example, a trader buys 15 Swiss Franc contracts at USD / CHF 1.0499 (buy USD and sell CHF) on the Chicago Mercantile Exchange to take a long position in USD – note that each contract consists of 125,000 francs. One week later, the price is now USD / CHF 1.0463 and the trader closes the position by selling the contracts (sell USD and buy CHF). In this example, the trader has made a profit of just over $6,100 USD:

Opening Position

Buy 15 contracts of 125,000 units each = 1,875,000

1,875,000 / 1.0499 (buy price) = $1,785,884 USD (you are long this amount)

Closing Position

Sell 15 contracts of 125,000 units each = 1,875,000

1,875,000 / 1.0463 (sell price) = $1,792,029 USD (proceeds from the sale)

Profit / Loss (Sell – Buy)

= 1,792,029 – 1,785,884

= +$6145 USD profit

While currency futures can be used for market speculation, there is an element of risk involved as prices could move against your position resulting in a loss. Note that the closer the contract is to the expiry date, the narrower the difference between the market price and the closing rate becomes, thereby reducing arbitrage possibilities. At the expiry date, you only receive the rate guaranteed in the contract, which negates any speculative profit.

Currency Market Spot Trades to Offset Currency Exposures

The last forex exchange hedge we will look at makes use of the spot currency market to enter into an equal but offsetting position that cancels any losses incurred by your exposure. The downside however, is that it also negates any profit that could result if the exchange rate moves in your favor. However, if your primary objective is to create an effective hedge for a situation where you think that losses are likely, a move in the opposite direction is remote so you should place less weight on this possibility as a deterrent to creating a hedge.

To see how an offsetting currency trade can be used as a hedge, consider the following example where Sarah, a resident of the UK, intends to buy a holiday property in a small coastal town in France. Sarah has saved most of the money she needs and this, combined with a number of fixed income securities due to mature in the next six months or so, will provide Sarah with sufficient funds to make the purchase. Sarah hopes to find a suitable property and close the deal in nine months to a year from now.

However, Sarah’s money is held in GBP and she is worried that the exchange rate could change substantially when she converts her savings to Euros thus eroding some of the buying power of her savings. In currency trading terms, Sarah is long GBP and short Euros, with a scheduled Euro deliverable looming in the future.

In order to lock in the current exchange rate, Sarah opts to open a currency trading account and sells GBP and buys Euros. By holding the Euros in her account until ready to purchase, Sara “locks in” the current rate until the time that she needs to close her position and use the cash to make her purchase.

This approach to hedging currency fluctuations is usually the least costly as currency trades can be completed through a forex broker / dealer with the costs embedded within the spread. Spreads have narrowed considerably the last few years on the more liquid pairs in particular which further reduces the overall cost to implement.

In addition, margin accounts commonly offer at least a 50:1 margin ratio which means that Sarah can control a considerable amount of capital without committing her entire savings amount to create the hedge. Of course, this also means that should GBP actually strengthen against the Euro, Sarah may be required to add to her margin. However, the fact that the Pound is now worth more vis a vis the Euro, means that Sarah is really not losing money.

Related Links

Introduction to Hedging

Stock Price Hedge Using a Pairs Order

Interest Rate Hedge

References

1. ↑ Forex Hedge Accounting Treatment offers a comprehensive look at GAAP principles relating to forex hedging.
2. ↑ http://www.cme.com/about/ins/caag/histinnovation.html