The use of hedging strategies in managing currency risk within a company is a sensible, prudent course of action especially when the consequences of leaving the organisation open to currency fluctuations can lead to significant and unnecessary financial losses.
To explain the hedging strategies available, it might be helpful to use the example of a Spanish fruit distributor that has just agreed a one-year contract to supply tomatoes to a UK supermarket. Let’s assume the value of the contract to the Spanish business is £100k per month.
As the UK supermarket will be paying in sterling, the Spanish company, which reports its financial results in Euros, will need to exchange the sterling amount it receives into Euros.
Ideally, the Spanish company should look at the hedging strategies available to it but it may be happy to take on the currency risk and do nothing.
Spot rate conversion
If the Spanish company decides to do nothing, this means that as and when the £100k is received each month, it is exchanged into Euros at the prevailing market rate on the day of conversion (known as the spot rate). This approach provides no certainty over the Euro value of cashflows for the duration of the contract.
For example, in January say, the FX rate might be £1: €1.20 and the company would receive €120,000. But, what if during the course of the year, sterling depreciates by 10% against the Euro such that by December the prevailing exchange rate was £1: €1.08. Now, the Spanish company would only receive €108k for its tomatoes which would mean its revenues have fallen by €12k that month.
Of course, sterling could have gone the other way and appreciated in value against the Euro by 10%, leading to higher revenues and profit margins for the Spanish entity, but the fruit distributor is in the business of exporting tomatoes and not second-guessing the currency markets.
So, its foreign exchange exposure should be managed in such a way that it doesn’t erode the profit margins it has built into the agreed sale price of its tomatoes.
Forward contracts
A forward contract is a written contact agreed between two parties to buy and sell different currencies at an agreed price at a specified future date. It provides protection against adverse currency rate movements.
A forward exchange rate is calculated using the prevailing rate of exchange (spot rate) on the day the contract is agreed, adjusted for the interest rate differential between the currencies involved.
In our example, the Spanish company can enter into a forward contract which agrees in advance the amount of Euros it will receive for its sterling revenues over the course of the one-year contract.
Forward contracts can also be used by private individuals, for example, by a UK based individual buying a property overseas. Quite often there can be a delay between viewing a property and completing on its purchase, during which time the currency exchange rate could move adversely against you.
Rather than paying more for the property on completion or even pulling out of the purchase, a forward contract can allow you to lock in the prevailing exchange rate at the time of viewing.
Forward contracts have the advantage of providing certainty around future cashflows and also protect against unfavourable currency exchange rate movements. However, because the FX rate is locked in, there is no benefit to be gained from the value of sterling going up against the Euro.
Currency options
There are other more bespoke hedging strategies available which for a small fee (similar to an insurance premium) allow you to hedge currency risk.
For example, a company or individual could enter into an arrangement to acquire the right (but not the obligation) to convert a currency at an agreed fixed rate at a specified future date. This is known as a currency option.
This arrangement allows the purchaser to participate in some of the upside in favourable exchange rate movements but protects against the worst of any adverse rate movements.
However, depending on the nature of the agreement, this kind of option can be very expensive to put in place and the product could also have a structure that might force you into conversion at the worst-case rate.
Currency risk
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