Here we look at five simple strategies business can use to protect profits against volatile currency moves.
Before we go into the below, it’s important that if you are considering currency hedging solutions that you fully understand your potential downside. In some strategies, there may be 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 CHFEUR 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.
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.
So for example, if you are a business and you have issued an USD invoice 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 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 EUR, 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 principle 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. Leveraged Positions
Using a CFD, Future or ETF to protect yourself from adverse currency moves is very simple.
The key points to remember with hedging is that 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.
Which corporate foreign exchange brokers offer commercial FX hedging solutions?
Here is a list of brokers that are regulated by the FCA where you can offer commercial hedging solutions
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Richard started the Good Broker Guide in 2015 and has been a broker for 20 years most recently at Investors Intelligence and previously a multi-asset derivatives broker at MF Global (Man Financial). Richard started his career working as a private client stockbroker at Walker Crips and Phillip Securities (now King and Shaxson) after interning on the NYMEX oil trading floor in New York and London IPE in 2001 & 2000.