What is currency hedging?

Article reviewed by Andrea Michael - Director - Institutional Sales - StoneX Pro

---

Currency hedging is a financial strategy that helps businesses manage the risks associated with foreign exchange (FX) fluctuations. It involves using various currency hedging solutions, such as forward contracts, options, or swaps, to offset potential losses caused by currency volatility. This allows businesses to reduce financial uncertainty, protect profit margins, and maintain more predictable cash flows.

For businesses engaged in international trade or investments, currency fluctuations can pose significant challenges. For example, a U.S. based company importing goods from Europe faces the risk of the euro strengthening against the dollar, which would increase import costs. Currency hedging provides a way to stabilize these costs and protect the company’s financial position.

Common currency hedging strategies include:

• Options contracts: Options contracts provide the right, but not the obligation, to exchange a currency at a predetermined rate at a future point in time.
• Forward contracts: Forward contracts lock in an exchange rate for a future transaction.
• Currency swaps: Currency swaps involve exchanging cash flows in different currencies.
• Natural hedging: Natural hedging involves offsetting foreign currency risk without using financial instruments.

For companies, currency hedging can reduce uncertainty and make it easier to forecast revenue and expenses. It also plays an important role in risk management by isolating currency risk from broader business activities.

Understanding currency risk

Businesses or investments involving foreign currencies are exposed to currency risk, also known as exchange-rate risk. This refers to the uncertainty caused by fluctuations in exchange rates, which can impact the value of investments and business transactions.

Consider a U.S. investor purchasing an asset in Europe that’s denominated in euros. To make the purchase, the investor converts U.S. dollars into euros at the current EUR/USD exchange rate. At this stage, the investor would be considered ‘long’ in euros, since they own euros instead of dollars. When they sell the investment and the funds are brought back to the U.S., the euros must be converted back into dollars at the prevailing exchange rate. The difference between the exchange rate at the time of purchase and the time of sale would result in either a gain or a loss for the investor.

If the euro strengthens against the dollar during the investment period, the investor gains additional value when converting euros back to dollars. If the euro weakens, however, the investor realizes a loss upon conversion – regardless of how the underlying investment performed.

This fluctuation in exchange rates during the holding period is called currency risk.

For businesses, currency risk can impact the cost of imports, the revenue from exports, or the valuation of foreign assets and liabilities. Managing this risk is an essential part of maintaining financial stability and predictable outcomes, which is where currency hedging comes in.

How does currency hedging help mitigate foreign exchange risk?

Currency hedging can help companies mitigate foreign exchange risk by providing tools to lock in exchange rates or offset potential losses from currency fluctuations. These tools include forward contracts, options, and currency swaps, all of which can be used by companies to stabilize costs and protect revenues from currency volatility.

For example, a company can use a forward contract to secure an exchange rate for a future payment. This can reduce exposure to volatility and protect the business against unfavorable exchange rate shifts.

What are the most common currency hedging strategies?

Some of the most common currency hedging strategies include options, forwards contracts, currency swaps, and ETFs. These strategies can be executed through an FX liquidity provider. Below, we explain these strategies and provide a currency hedging example for each.

Options contracts

Currency options (FX options) give businesses the right, but not the obligation, to buy or sell a specific amount of currency at a set price within a certain timeframe. This flexibility allows companies to lock in an exchange rate while still benefiting from favorable market movements if they occur.

For example, consider a U.S. based business expecting to receive payments in euros. If they fear the euro might lose value, they could purchase a currency put option that allows them to sell euros at a predetermined exchange rate. If the exchange rate ends up being better than what was locked in with the options contract, they can choose to let the option expire and trade at the more favorable market rate.

Companies pay an upfront cost (premium) to buy the option. If the option isn’t exercised they lose the premium, however this cost can be worth it to avoid potential losses from currency fluctuations.

Forward contracts

Forward contracts are agreements between two parties to exchange one currency for another at a specific exchange rate at a future point in time. Unlike options, forwards contracts require both parties to complete the currency transaction.

In a currency forward, two parties agree on a specific exchange rate to exchange their currencies on a future date, with no upfront costs. On the agreed date, the two parties exchange the chosen amounts of currency at the predetermined exchange rate, regardless of the prevailing exchange rate at the time.

For example, consider a U.S. company agreeing to exchange $1,000,000 for euros at an exchange rate of 1 USD = 0.85 euro, set for three months in the future. If in 3 months time, the actual market exchange rate is 1 USD = 0.80 EUR, the company still gets 0.85 EUR per USD, which means they get more euros than they would have under the current market rate.

In this example, the company has used a forward contract to hedge against the risk of a weakening U.S. dollar. This helps make budgeting more effective and prevents unexpected costs from currency fluctuations.

Non-deliverable forwards (NDFs) are often used for currencies with restrictions or limited liquidity. These contracts do not require actual delivery of the currency.

Currency swaps

Currency swaps are financial agreements where two parties agree to exchange interest payments – and sometimes principal – on their respective debts in different currencies.

For example, if Company A has a debt in U.S. dollars and Company B has a debt in euros, in a currency swap:

• Company A will pay the interest on Company B's euro-denominated debt, while
• Company B pays the interest on Company A's dollar-denominated debt.

The principal is not swapped up front and each company will still repay its own debt principal in its own currency at the end.

In a cross-currency swap, the two companies agree to also exchange principal amounts at the start and end of the agreement in addition to exchanging interest payments.

Natural hedging

Natural hedging involves a business mitigating currency risk through their own operations as opposed to using financial products like options or forward contracts. For example, if a company operates in multiple countries and has both revenues and expenses in different currencies, it can balance these out to offset the impact of currency fluctuations.

Consider a U.S. based company that sells products in Europe and also buys supplies from Europe. The money the company earns from sales in euro can be used to pay for its euro-denominated expenses. This helps protect the company from fluctuations in the exchange rate because the revenue and costs are in the same currency.

Natural hedging is considered more cost-effective since it doesn’t involve purchasing financial instruments. However, it relies on a company having significant cash flows in matching currencies, which isn’t always possible.

Currency ETFs

Currency exchange-traded funds (ETFs) track baskets of currencies or specific currency pairs to provide exposure to foreign currencies without directly engaging in currency trading.

Investing in a currency ETF allows companies to hedge against a currency while simultaneously diversifying their portfolio. For example, a U.S. business with international operations may invest in an ETF that tracks the euro-to-dollar pair to hedge against potential losses from currency volatility in Europe.

That said, it’s important to consider an ETF’s expense ratio and liquidity as these two factors can influence the cost and effectiveness of the hedge.

How does foreign currency exposure impact global businesses?

Foreign currency exposure can have a direct impact on a company’s profitability and financial stability. For example, when a domestic currency strengthens, it reduces the value of revenues earned from foreign markets. On the other hand, a weaker domestic currency increases the cost of importing goods or raw materials. This currency volatility can make it challenging for businesses to accurately forecast earnings and maintain stable profit margins.

How does currency hedging differ from speculation in foreign exchange markets?

Currency hedging and speculation are two different financial strategies:

• Currency hedging focuses on minimizing the risk of unfavorable currency movements to protect a company’s profits, costs, or investments from exchange rate volatility.
• Speculation, on the other hand, involves taking calculated risks to profit from expected changes in currency values. Investors and traders speculate on future exchange rate movements to earn a potential profit.

This material is for informational purposes only and should not be considered as an investment recommendation or a personal recommendation.