Foreign exchange (FX) hedging helps you protect your investment from market volatility, currency fluctuations and other risks.
When you’re trading with overseas clients, hedging is essential to maintain your cashflow.
Whether you choose to outsource your FX to a third-party specialist or handle it in-house, knowing which methods to choose can be tough.
There are several methods of hedging currency risk. Some may be more suitable for your company. Here is a quick overview to help you choose.
1.) Use Forwards Contracts To Lock In Value
You can use your knowledge to predict movements between currencies then use forwards contracts to your benefit.
If you expect a less favorable exchange rate down the line, you can set a better one now, then wait for the forwards contract date before trading.
Forwards are customisable, and you can choose your own contract and rate, allowing you to offset any expected losses with precision. Forwards ensure the trade, and it is then compulsory.
The downsides are based on market volatility. You may lock in a rate now that moves up in future instead of down.
In that case, a spot trade on the day or a different pre-set rate would have been better. But futures offer a useful tool for hedging with the right research.
2.) Futures Are Like Forwards But More Rigid
Futures work in principle the same as forwards. You make a deal for an exchange at a future date at a rate set now.
When the contract date arrives, you make the exchange for whatever price your agreed.
The difference, you can make forwards independently; futures use official exchange centres for the trade.
This makes futures contracts standardized and far less customizable – the exchange regulates the trade. If you need custom durations or terms, forwards are better.
3.) Choose Currency Options To Stay Flexible
Like forwards and futures, currency options set a future date for the trade. You agree to an amount and a duration.
When the date arrives, you have the option to trade at the predetermined rates.
This means that options are non-compulsory, and if the market moves the other way, you have no obligation to make the trade. You can make two main types of options trades: puts and calls.
If you expect your base currency to rise against the quote currency, you would use a call option to gain profit from the relative rise.
Put options work the other way. If you think the quote currency will rise in relation to the base currency, you would use a put option to profit from the movement.
In either case, if things look set to go the other way, you can opt to sell your options.
4.) Spot Rate Trades Are Fast But Risky
Spot trades are the most straightforward method of currency trading. They work the same as exchanging money before going on holiday.
The foreign exchange market sets the rate for each currency pair, and you trade at that time for that rate, simple.
Spot value contracts require delivery of the rate either at the time or within a few days. It is a what-you-see-is-what-you get trade.
Unlike futures and forwards, there is no interest rate or market fluctuation to consider between now and the delivery date; you trade for the current rate and that’s it.
The problem with spot trades is that you need to act fact to profit. The second a currency pair moves in your favour; you need to capitalise on it.
This can lead to risky trades, and you could see a loss in a matter of hours.
5.) Risk-Sharing Agreements And Domestic Currency
You can reduce or eliminate your risk in business with partners overseas by asking them to pay you in your own currency.
Assuming your own currency is more stable than the other, you avoid the risk of invoicing in the foreign currency only to see it plummet in value days before the delivery date.
However, you are putting all the risk onto your overseas partner. Many businesses may hesitate to trade this way might even question the ethics of this type of risk reduction.
Risk-sharing agreements solve this issue. You and your overseas business partners agree on an invoice amount and mutual risk level if the currencies move. You split any difference in the agreed amount 50/50 to keep things fair.
Which Method Works Best For You?
You have plenty of hedging methods to choose. This guide should help you get started, but you need insights into currencies and your own business to pick the right methods for you.
External FX companies can help give you peace of mind. The extra time and cashflow lets you focus on other areas on your business.
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