FX Hedging for Beginners: Reduce Foreign Currency Risk

What is FX hedging?

FX hedging is a currency risk management strategy businesses use to protect themselves against losses caused by fluctuations in foreign exchange rates. Essentially this means a business purchases financial products to protect itself against unexpected movements in exchange rates.

Why do businesses hedge FX?

Protect against losses caused by unfavourable currency movements

Provide certainty about future cash flows

Can improve a business’s profitability

Can reduce financial risk

When a business hedges its FX exposure, it enters into a financial contract that can lock in an exchange rate for a future date or protect the business if exchange rates move the wrong direction. This means the business knows exactly how much it will pay or receive in its home currency, or at least will know a worst-case scenario, regardless of how the exchange rate changes. By doing this, CFOs and treasurers are able to forecast their financial performance more accurately. Many businesses also consider hedging FX exposure to prevent their margins from being compressed. Depending on the business, FX exposure can have very noticeable effects on top-line and bottom-line financial performance.

How does FX hedging work?

When a business hedges its currency exposure, it enters into financial contracts that mitigate the potential of financial loss. The finer details on this depend on the type of currency hedging method (which we’ll go over below). Depending on the business use case, companies can select different methods to help protect against losses caused by fluctuations in exchange rates.

What are the different types of currency hedging? 

Internal hedging Methods

Invoicing in the local currency – This means invoicing the customer in the currency of the country where it is located. You’ve probably seen many US SaaS businesses that charge their UK customers in dollars. This protects the US dollar based company from losses if the dollar value strengthens and pushes the currency risk onto its customer.

Leading and lagging – This is the process of delaying or accelerating foreign currency payments. Say the home currency weakens; the company may delay payments until the exchange rate moves in their favour.

Matching (also called natural hedging) – This means that the company matches its foreign currency receivables with its foreign currency payables. This helps protect the company from losses if the value of its home currency strengthens.

External Hedging Methods

Averaging – Averaging allows businesses to systematically spread their risk over as much time as possible, smoothing out short-term volatility. Many businesses that want to focus on business growth instead of where currencies are moving use averaging to minimize the risk of transacting many of their currency conversions at an inopportune time.

Layered hedging – Layered hedging is a popular hedging strategy for larger companies. Layered hedges are spread over time and may help reduce the impact of market volatility to provide businesses with good visibility and a high degree of certainty on their forecast figures.

Forward contracts – These contracts allow businesses to lock in an exchange rate at a future date. Companies that want to know exactly how they’ll pay or receive, regardless of the exchange rate changes often choose to use forwards.

Options contracts – These contracts give the company the right to buy or sell a currency at a certain price on a future date. Many options have up-front costs, but they can be more flexible than forward contracts, as there is no obligation for the company to act on their options.

Swaps – Swaps are financial transactions in which two parties exchange currencies, but also pre-agree to exchange them back at a future date at a predetermined exchange rate.

Non-Deliverable Forwards (“NDF”) – NDFs are short-term contracts where two parties agree to exchange the difference between the contracted rate and the future spot price of a currency. The total amount of the currencies are not exchanged. Rather, only the net gain or loss is exchanged, which gives it the name “non-deliverable.”

Automating currency hedging

Many treasurers are looking into ways they can automate manual tasks such as currency risk management. Companies like Bound have put in place products to make this possible, giving businesses a cockpit of tools to make this a smoother process and improve efficiency.

How to choose the right hedging strategy

Businesses have the choice of internal and external hedging methods, they first need to decide which makes more sense for their business. The best hedging strategy for a company will depend on its specific circumstances and the way foreign currencies move through their businesses. Where treasury teams are uncertain of which strategy suits their needs, they should consult a financial advisor to choose the right hedging strategy for their needs.

Currency hedging use cases

Paying international offices and staff in foreign currencies

Receiving international customer revenues in foreign currencies

Timing regular foreign currency expenses with the relevant currency balances

Repatriating revenues to base reporting currency

Expanding into new markets / active in multiple markets

Protecting their bottom line, no matter the use case

Conclusion

FX hedging is a complex topic, but it can be important for businesses that operate in multiple currencies to manage risk. By hedging their currency exposure, businesses can protect themselves from losses caused by fluctuations in foreign exchange rates.