What is a Currency Hedging Strategy
A currency hedging strategy is what businesses use to reduce their foreign exchange risk. The different types of currency hedging strategy can be active or passive and include currency forward contracts, options and derivatives.
Here we examine a few simple ways to protect you and your business capital from volatile currency markets.
Best Accounts for Currency Hedging
- Global Reach – best overall for currency hedging
- Currencies Direct – best for customer service
- OFX – best for market analysis and data
- Key Currency – best for personal service
Advantages and disadvantages of money market hedge
Here we explain the main pros and cons of using managing your currency exposure through money market hedges.
Advantages of a money market hedge:
- Lock in profits – you can hedge your exposure through currency forwards or derivatives to lock in the currency
- Cost-efficient – there is a small upfront cost to money market hedges that can significantly outweigh any financial loss from a currency exchange rate moving against you.
- Simple – money market hedges are simple to implement through a specialist currency option provider.
The risks of currency hedging
- Positive price moves – The main risk of hedging currency exposure is that the market will move in your favour and you will not benefit from positive price moves. However, with foreign exchange it is very easy to mitigate risk, but very difficult to speculate for profit.
- Unexpected losses – some complex currency hedging strategies like options and derivatives can result in big losses if not properly structured.
- Counterparty risk – as most currency hedging is not deal on exchange but OTC (over the counter) your trade or hedge is only as good as the provider you hold it with. If you’re currency broker defaults you may lose the benefit of an open hedge.
Examples of when currency hedges are useful
Here are two examples of the recent devaluation of GBP in real money terms.
Businesses buying stock from abroad.
Over a year it is possible for popular currency pair prices, like the GBP EUR or GBP USD, to move more than 20%. An order that cost £100,000 worth of stock in January could cost £120,000 in December. By using currency hedging strategies like a currency forward to lock in currency exchanges rates you can hedge against adverse exchange rates.
Individuals buying a property abroad
Individuals who find the perfect holiday home and have budgeted £500,000 for the purchase. As you will have to agree on a purchase price in the local currency, you will need to ensure that the exchange rate does not move against you. If the exchange rate moves 20% against you a £500,000 property could end up costing £600,000. Individuals buying property abroad can hedge against this using a currency forward to buy foreign currency on a buy now pay later basis.
Currency hedging strategies for companies
Any business that deals internationally should consider currency hedging. Not correctly hedging foreign exchange exposure can narrow margins or turn a profitable year into a loss. Examples of companies who would need effective currency hedging strategies are the travel industry, importers, exporters and digital service companies.
For these businesses to effectively hedge their currency exposure they would need to decide how much risk they are prepared to take if any, if they have a view on where the market may go, some budget assigned for funding the hedges and suitable currency for foreign exchange brokers. For more information on currency hedging for business read our guide.
Understanding and applying currency hedging forward contracts
Currency hedging forward contracts are really very simple. They allow either individuals or businesses with exposure to currency risk to protect themselves from adverse moves in the foreign exchange market.
The main thing to consider when looking at hedging currency exposure with forward contracts is your appetite for risk.
If you are very risk-averse and like to budget precisely then a forward contract is probably the most effective way to hedge. However, if you are not averse to taking some risk on your currency exposure there are other currency hedging tools that can be used.
Different types of currency hedging tools?
There are a few basic hedging tools you can use to lock in an exchange rate and reduce risk in volatile markets.
There are several different types of tools for currency hedging
- Currency forward contracts – buy now pay later
- Stop loss entry orders – buying currency before it gets worse
- Foreign exchange options – the right (but not the obligation to buy a certain amount of currency at a certain date)
- Leveraged speculative/hedged positions – using derivatives like CFDs and futures to trade spot forex
Using a currency broker can help a wide variety of business clients exchange and send money worldwide. From importers and exporters currency broker hedging tools help these organisations manage and exchange their funds more effectively.
If you are a business, you are in the business of making money. By definition, that means cutting costs and effectively making savings. Currency hedging tools can help you do both and may save you time and money.
Getting a good exchange rate isn’t the only reason businesses set up a currency hedging account.
Currency brokers offer a more personal and proactive service that banks are often unable to provide.
When and what currency hedging tools to use?
If you have the money now.
You can just convert it into EUROs via a spot fx trade and let it sit there in your EURO account until you need it.
If you only have some of the money now.
You can use a currency forward to lock in the current rate for up to 1 year in advance. A small deposit of 5% for 6 months forward or 10% for 1 year forward would be required as a deposit. The balance of the GBP would then be due at the settlement date when you receive the foreign currency.
If you are a sophisticated Forex trader.
You can buy a currency option. These are generally only offered for conversions over £1m. Like a stock option, you buy the right, but not the obligation to buy a set amount of currency in the future. There is an upfront non-refundable premium and the cost of protecting your price.
If you are a Forex speculator
You can open a forex trading account and place a leveraged currency trade. By doing this you can hedge the entire amount of currency for in some cases a deposit of only 0.5%. You will need to fund your account with enough to cover the daily profit and loss. When you need to do the actual conversion you close the position and the additional cost of the currency should be offset by the profit from the trade.
You can do this without having to pay capital gains tax (at the moment) with a spread betting broker or use a traditional Forex broker.
One thing to be mindful of though is that if you do put a currency hedge on or lock in the current rate and Sterling begins to strengthen you will not benefit from the rise.
Be mindful, it is very simple to protect yourself from losing money, but very difficult to predict the direction of a currency with the view to making a profit by speculation.
The CME, where GBP is traded against the USD as a currency future has recently reported that net-short positions are at an all-time high. Suggesting that speculators and hedgers are already protected and betting on the market going down. Excessive bearish sentiment is often a warning sign that things are about to change.
An example of a currency hedging strategy using futures may be to cover the exposure of a portfolio of USD-denominated stocks. If you have $100,000 worth of stocks and are worried that the USD will move against you making that $100,000 worth of stocks worth 10% less in GPB you could sell $100,000 worth of GBPUSD futures. That would make your exposure flat so if your USD stocks were devalued by adverse currency moves your futures position would show the equivalent profit. However, if your USD stock increase in value against GBP, your futures position will show the corresponding loss.
Currency Hedging Solutions 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 forward contracts
- Spot currency conversions
- Stop entry orders
- Compare currency brokers here
- Currency futures, CFDs & ETFs
- Currency swaps
- Currency options
- Compare forex brokers here
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:
Compare Currency Accounts
Online Money Transfers
Business Foreign Exchange
Currency Transfer Reviews
Currencies Direct review
Global Reach review
Key Currency review
Compare Currency Brokers for Currency Hedging
Currency hedging can protect yourself from fluctuations in the price of the pound if you regularly exchange currency for your business. Compare currency brokers for hedging currency exposure.
|Currency Broker||Number of Currencies||Min Transfer||Forward Contracts||Personal Transfers||Business Customers||Same Day||Currency Options||Year Founded||Annual Transfers||Amount of Customers||Get A Quote|
|42||£1,000||12 months||✔️||✔️||✔️||❌||2015||£2bn||50,000+||Visit Key Currency|
|55+||£250||12 months||✔️||✔️||✔️||❌||1998||£2.4bn||1,000,000||Visit OFX|
|30+||£3,000||24 months||✔️||✔️||✔️||✔️||2001||£6bn||30,000+||Visit Global Reach|
|40||£100||24 months||✔️||✔️||✔️||❌||2004||£7.5bn||325,000||Visit TorFX|
|40||£100||12 months||✔️||✔️||✔️||❌||1996||£7.5bn||325,000||Visit Currencies Direct|