It is important to use a hedging strategy to eliminate currency exposure and the attendant risk associated
with currency movement. Luckily, a number of vehicles for hedging Foreign Exchange (forex) risk exist. They all either involve finding a way to buy foreign currency now at today's
exchange rate (so you know what your costs are and have a sound basis on which to set the price of your product/service), or finding a way to gain the right to buy
foreign currency at a later date at today's fixed exchange rate.
Hedging allows you to manage the risk and reduce potential risk. If you don't hedge, it's tantamount to speculating that the foreign currency rate will stay the same.
If the rate ends up moving unfavorably, your speculation can be costly.
A Scenario
We'll go through several hedging vehicles using the following scenario:
Scenario: As a Canadian based company, you sign a contract where you have to pay USD 500,000 in six months. Suppose the current USD/CAD rate is 1.1150
Remember that this scenario could equally apply to a contract due in six months or a parts purchase delivered COD. The principles are the same, and could apply equally to both the payer and the payee.
How much is this USD 500,000 really going to cost you in CAD? It will depend on the exchange rate fluctuations over the next 6 months. Using this scenario as an example, we will briefly review five hedging solutions available today:
*Open a USD account;
*buy USD 500,000 and deposit it into the USD account
*By buying the USD up front, today's exchange rate is locked in, and future USD fluctuations do not affect the cost of the contract.
There are several problems with this approach:
1. It is unlikely you will get a good exchange rate or competitive interest rate at the bank;
2. You need to pay roughly CAD$557,500 or more to buy the USD up front, using scarce cash resources. You may not have these CAD funds or an available credit line.
3. If you are using a credit line to fund the USD bank account, the CAD credit line will likely have a higher rate of interest.
Solution B: Currency Forward Contract
At a major bank, ask for a currency forward contract. A currency forward contract is a negotiated agreement between two parties to exchange specific amounts of currency at a set rate on a particular day. The forward rate is priced based on the current exchange rate, the interest differential for the contract time, a cost to cover potential negative changes to the interest risk differential, and a flexible built-in commission for the forward contract provider.
Currency forward contracts tend not to be very flexible, so there are several disadvantages:
1. Often, the forward rate includes an uncompetitive exchange rate or high built-in commission, making this solution quite costly;
2. You would require many forward contracts for more complicated scenarios (such as monthly payments)
3. Since a forward contract is between two parties, there is no secondary market for the purchase and sale of these contracts, making them rather inflexible or expensive to extend or terminate early.
Solution C: Futures Contract
Buy a forex futures contract. Futures are similar to forward transactions, in that the cost is based on the current exchange rate, the interest differential for the contract time, an amount to cover potential negative changes to the interest risk differential, and a formal commission.
The major advantage of futures contracts over forward contracts is the existence of a liquid secondary market so they can be sold at any time on the open market and do not have to be held until their maturity date. Futures contracts can be traded on organized exchanges such as the Chicago Mercantile Exchange (CME) or London International Financial Futures Exchange (LIFFE). These exchanges dictate contract specifications, such as expiration times (third Wednesday of March, June, September and December), face amount, and margin requirements.
Disadvantages of futures contracts for the purpose of hedging include:
1. Futures contracts involve not just a spread, but also a commission;
2. Face value of futures contract are fixed. For example, British pound futures are sold in GBP 62,500 and Euros are generally sold in lots of EUR 125,000, making it difficult to make up the exact value of your exact requirements;
3. A margin deposit must be posted and maintained daily;
4. Limited expiration times;
5. It is unlikely you will get a good exchange rate or competitive interest rate on your margin account;
6. Futures contracts are typically speculative, so taking delivery of the money at the end of the term is not expected and may cost commission.
Solution D: Currency Options
Buy a currency option at a bank. A currency option gives the holder the right, but not the obligation, to sell or buy a face amount of currency at a set price, on or before a given date. A currency option has a strike price, being the amount for which the currency can be bought or sold for, and an expiration date. US options can be exercised any time up to and including the expiration date, whereas European options can only be exercised on the expiration date. There are two types of options. Call options give the holder the right to buy a given amount of a currency at the strike price. Put options, on the other hand, give the holder the right to sell a given amount of currency at the strike price.
Options are one-sided contracts (options, but not obligations) that are priced based on a number of variables (exchange rates, interest differentials, duration of contract, historical exchange rate volatility, and a built-in commission for the provider). They are a method of speculating on future currency movements, and you pay a price for that right to speculate.
Like futures, the major advantage of options over forward contracts is the existence of a liquid secondary market. As a result, options can be sold at any time on the open market and do not have held until their expiration date.
The disadvantages are also similar:
1. Options traded on formal exchanges must be purchased in fixed face values and lot sizes. Some banks offer their own options with any notional amount, but these options may cost you more as you will not be purchasing the option in an open market.
2. The options have to be purchased. There is a cost involved, and premiums to pay.
3. You will bear the risk and potential cost associated with the difference between the amount to hedge and the fixed option amounts.
4. They have expiry dates.
Solution E: FX or Forex Trade
Currency spot hedging is surprisingly straightforward; given the new generation of currency hedging platforms. All transactions can be completed over the Internet using a standard Web browser, at any time, 365 days a year. No bank visits are required.
PlumblineFX can introduce you to the best counterparties in the industy; counterparties that are currently being used by many fortune 500 companies.
In the above scenario, you would open a USD-based FX Trading account, deposit margin capital of, say, 10% or $75,000, and buy (long) 500,000 USD/CAD today. (That is, you would open a trade whereby you buy 500,000 USD and sell 557,500 CAD.) You would close this position six months later when the payment is due and withdraw the margin capital plus/minus profit/loss and the interest rate differential.
If the USD went up over 6 months: If the new USD/CAD rate is 1.2150 after 6 months, your long position will be worth approximately 50,000 USD more when you close it (plus or minus the interest rate differential).
If the USD went down over 6 months: If the new USD/CAD rate is 1.0050 after 6 months, your long position would cost approximately cost 50,000 USD when you close it (plus or minus the interest differential).
What are the costs?
The cost of this type of hedging is the cost of the spread, which is typically 6 bases points, or around $300.00 for the example scenario, and the interest rate differential depending on the two currencies you're trading. (You would still need to pay the unavoidable bank fees and bank exchange rates when you make the actual payment, but only at the time the payment is due.)
The disadvantage of this approach is that proper margin must be maintained at all times to avoid closing out your hedge prematurely. To reduce this possibility, you may wish to deposit more margin then the required 10%.
Cost Comparison chart
Costs
A
Bank Account
B
Forward Contract
C
Future Contract
D
Currency Option
E
FX Trade
Overall Costs
Special Charges
Large Spreads
Large interest differential
Interest risk premium
Commissions
Volatility charge
Spreads: Bank accounts typically charge spreads 2% or 3% above interbank spreads.
Forward contracts, future contracts and currency options charge close to interbank spreads, but do have the following built-in or
explicit commissions and other special charges:
Interest differential: All hedging methods charge an interest differential on the currencies, either built into the rate offered or
as a separate amount charged. Bank accounts typically charge interest 2% to 3% above interbank rates for funds borrowed to purchase
the foreign currency (and pay much lower rates for funds deposited).
Interest risk premium: Interest risk premium is a variable amount charged by the issuing party for potential changes in interest rates.
Commissions: Forward contract and option contract suppliers build commissions into their products based upon how much they can charge the buyer.
The commission is built into the forward rate or included in the amount paid upfront for an option (it is also called the premium).
Volatility charge: Options are one-sided contracts which cost an upfront premium to purchase. Options offer the right, but not the obligation,
to engage in a future transaction. An estimate of the future volatility of the foreign currency over the life of the option is built into the option pricing.
While an individual option may incur a large payout, other options will expire without being exercised.
Features
A
Bank Account
B
Forward Contract
C
Future Contract
D
Currency Option
E
FX Trade
Early Exit?
Extend beyond expiry date?
Hedge exact amount?
Change hedge amount?
Early exit: Forward contracts require break costs if you exit early. You risk market uncertainty by selling a future contract, or selling/exercising a currency option.
Extensions beyond expiry date: Bank accounts and Spot hedging accounts have no expiry dates. The other products will require you to enter into new hedging contracts or risk currency fluctuations between the expiry date and when the foreign exposure is settled.
Hedge exact amount: Contracts and options only offer fixed lot sizes. FX Trade and bank accounts allow you to hedge to the nearest unit. Forward contracts in theory may be structured to exact amounts, although often the amounts are not precise.
Change Amount: You can change the hedging amount by any amount for bank accounts or with hedge accounts. For contracts and options, you can only add or sell/exercise a fixed lot size.
Credit Requirements
A
Bank Account
B
Forward Contract
C
Future Contract
D
Currency Option
E
FX Trade
Upfront Cash Requirements
All hedging options require either upfront cash, or require necessary credit arrangements with the counterparty. A bank account requires the largest amount of upfront cash (the full hedge amount). Currency options must be purchased upfront with cash. Forwards will only be offered as part of your overall credit arrangement with the supplier, and any resulting forward contracts will reduce your available credit lines. Future contracts and Spot hedging accounts will require adequate margin amounts to cover the necessary credit requirements.
Advantages Unique to a Forex Trade
To summarize, some of the advantages unique to using a spot for hedging include:
Forex trading allows the hedger to execute any size of transaction. Unlike futures or options which are sold in set block sizes. With an forex trade account a company can hedge exactly the amount required—the perfect hedge. Down to $1.
There are no commissions or premiums charged for executing a trade. The only amount you pay is the low spread, plus the interest rate differential.
Unlike currency forwards, forex trade positions can be settled at any time, 24 hours a day, 365 days a year. The hedger never needs to hold on to a disadvantageous position.
Forex trades are flexible. If you cancel, partially cancel, or increase the size of your order, you can easily increase or decrease your trade position.
