currency hedging for business

Here are five simple strategies businesses can use to protect profits against volatile currency markets.

It is important that if you are considering currency hedging solutions where you have a full understanding of your potential downside.

In some strategies, there may be a significant downside if the market reaches a certain level.

If a broker tells you that the market reaching a certain point is unlikely, be mindful. There are always black swan events that can move the market significantly in the short and long term, i.e. Brexit, Trump, the CHF EUR peg removal, subprime and so on.

You may also find our 10 step guide to a large foreign exchange transaction or our article on how to compare exchange rates between brokers helpful.

How to use currency hedging to protect your foreign currency exposure

Currency hedging tools are essential for businesses and individuals to reduce the risk of foreign currency price movements increasing costs. The major currency hedging tools are:

  • Currency forward contracts
  • Stop entry orders
  • Currency swaps
  • Currency options
  • Currency derivatives

1. Currency Forwards

Currency forwards are probably the simplest way to protect against adverse price moves. A currency forward allows you to buy a large amount of foreign currency now for a date in the future, without paying for it.

Here's more about what currency forwards are how they work and what they offer.

So for example, if you are a business and you have issued an invoice in USD to one of your American customers, but are worried that the value of the GBP against USD will be weakened by the outcome of the election, you can convert your USD now with a settlement date after the invoice is due to be paid.

A deposit of between 5% and 10% is due as a security margin, and the balance payable on settlement, it is possible to draw funds early or roll the forward over if need be if the invoice is paid sooner or delayed.

The main advantages of a currency forward are that if the currency moves against you, the value of your invoice is locked in. Of course, if it moves in your favour you do unfortunately miss out on the invoice being potentially worth more.

2. Stop Entry Orders

Stop entry orders allow you to protect your downside from the exchange rate moving against you, but leave room to benefit from a currency price moving in your direction.

If for example you are buying a Villa abroad and you know you have to buy 1m Euro, at the current rate of 0.8487 (1.1783 the GBPEUR way round) that would cost you £848,700. But if you only have £900,000 in the bank you need to make sure you buy the Euros before the price moves to 0.8900 (1.1236 the GBPEUR way round).

So you can use a stop entry to execute a trade to buy £1m Euro at 0.8900 without having to keep an eye on the market all the time. The benefit being that if the currency continues to go against you, there is no need to find additional capital.

However, if the currency moves in your favour to 0.8200 (1.2195) by the time you need the money it will now cost you £820,000 meaning you are £28,700 better off.

Stop entry orders differ from limits as limits relate to executing a trade when it reaches a price in your favour rather than executing a trade to avoid it getting worse.

3. Currency Swaps

If you are lending money in a foreign currency a currency swap is the ideal way to protect your principal and income.

A currency swap means you buy currency now and sell it back for a future date.

So if you are lending $1m at 10% from GBP over a year, you can buy the $1m and lock in the exchange rate for the $1.1m for settlement in a year. This mitigates the risk of your interest being wiped out by adverse currency moves.

The same is also true if you are running a defect in one currency account. You can use a swap to clear the balance, therefore, reducing the amount of interest you pay on the overdrawn foreign currency account.

4. Currency Options

Currency options provide a very low-cost way to lock in an exchange rate. There are varying degrees of flexibility from the on exchange FX options provided by the CME to absolute control using an OTC option.

An OTC FX option gives you the right, but not the obligation to buy a set amount of currency at a set date in the future. The cost is the premium and the exchange rate is set by the strike price.

5. Currency Derivatives

Currency derivatives let you hedge currency exposure by buying or selling an equivalent amount of inverse derivatives. For example, if you have a Euro exposure of 100,000 you can use a CFD, Future or ETF to sell 100,000 of Euros making yourself Euro neutral and protect yourself from adverse currency moves.

The key points to remember with hedging is; it is designed to protect your downside, not for speculation. Above all else, not correctly executing a foreign exchange transaction is arguably the largest hidden cost.

Different types of foreign exchange broker for Currency Hedging

There are two types of foreign exchange broker - currency brokers and forex brokers. Which offer the below types of currency hedging product:

Currency Brokers

  • Currency forward contracts
  • Spot currency conversions
  • Stop entry orders

Forex Brokers

  • Currency futures, CFDs & ETFs
  • Currency swaps
  • Currency options

The main reason there are two types of currency account provider is because of regulation. Currency futures, swaps and options require a provider to be heavily regulated by the FCA, whereas currency conversions and forward do not. The majority of currency brokers process large international transfers as their main source of revenue and it is not always cost effective for them to provide regulated services to only a small percentage of their clients. Currency derivatives are also highly complex financial products which can produce large and unexpected losses, especially in some extreme circumstances.

Here is a list of brokers that are regulated by the FCA where you can offer commercial currency hedging solutions:

Currency brokers

Forex Brokers

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