How to protect yourself from fluctuations in the price of the pound if you regularly exchange currency for your business.
Here we examine a few simple ways to protect you and your business capital from volatile currency markets.
Firstly, two examples of the recent devaluation of GBP in real money terms.
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.
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.
Two examples of when currency hedges are useful
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.
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.> Compare Currency Brokers >