Currency hedging is a strategy used to reduce your exposure to adverse foreign exchange price moves. There are different types of currency hedging strategies that can be active or passive and include currency forward contracts, options and derivatives and are all relevant to different types of situations.
How does currency hedging work?
In this guide, we examine a few simple ways to protect you and your business capital from volatile currency markets.
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.
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 point 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.
Advantages of hedging in the money markets
- 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.
Disadvantages and 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 your currency broker defaults you may lose the benefit of an open hedge.
Why use currency hedging strategies?
1. 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.
2. 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.
3. If you want to hedge against currency volatility.
You can buy a currency option to protect yourself from volatile markets. 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.
4. 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.
Different types of currency hedging accounts
There are two types of foreign exchange brokers – currency brokers and forex brokers. Which offer the below types of currency hedging products:
Currency brokers (transferring money abroad)
- Currency forward contracts
- Spot currency conversions
- Stop entry orders
- Compare currency brokers here
Forex brokers (speculating on the price of currencies)
- Currency futures, CFDs & ETFs
- Currency swaps
- Currency options
- Compare forex brokers here
The main reason there are two types of currency account providers 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.
Currency hedging for individuals buying a property abroad
Currency hedging can be used by individuals who have found the perfect holiday home and have budgeted £500,000 for the purchase.
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 needing 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 and if they have a view on where the market may go. They will also need some budget assigned for funding the hedges and suitable currency for foreign exchange brokers.
For example: Over a year it is possible for popular currency pair prices, like the GBP EUR or GBP USD, to move more than 20%. An overseas 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 exchange rates you can hedge against adverse exchange rates.
Brokers that offer currency & forex hedging
Of the currency hedging accounts we compare, only Global Reach offers physical currency hedging for taking delivery of foreign currency for transfers and international payments. Other providers we have compared like Saxo Markets and Interactive Brokers do offer currency hedging, but more for speculation that actual transfers currency exposure.
The main things to compare when choosing a currency options provider are:
- Currencies – how many currencies can you hedge against?
- Transfer size – what is the minimum amount you can hedge?
- Account types – what type of hedging accounts do they offer?
Global Reach Partners: Best for corporate currency hedging
Global Reach offer currency hedging products, which can play an important role in foreign exchange hedging including options and currency forwards wich can be used to create a balanced hedging strategy.
Interactive Brokers: Best for on-exchange currency hedging
Interactive Brokers offers currency hedging on over 100 currency pairs through 30 market centres worldwide. IBKR is most suitable for sophisticated currency hedging strategies for those comfortable with complex transactions such as options, futures and CFDs.
Saxo Markets: Best for DMA currency hedging
Saxo Markets offers heading on to 40 FX vanilla markets with maturities from one day to 12 months. Spreads are as low as EUR USD from 3 pips and USD JPY from 5 pips and also provide extensive option chain tools, options analytics and innovative risk-management tools.
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