Currency Risk Hedging – A guide

Whether you are an individual looking to purchase a house abroad, buy a car/boat or simply planning to send money to a loved one overseas you will be affected by currency risk. Similarly if you are a  business that imports or exports goods and services abroad you will have a money transfer requirement that is affected by currency risk. For small businesses foreign exchange market volatility has a huge impact on conducting international business.  Large movements in the exchange rate can often result in big loses for companies that have not considered hedging their foreign currency risk exposure.

Currency risk essentially comes from the movement in the exchange rate between two currencies. The price at which you will be able to buy or sell a certain amount of currency will be affected by the exchange rate. If you are planning to make a large overseas payment the exchange rate at the time of your currency transaction will massively impact the total cost of your transaction.

How to reduce currency risk exposure

If you are a business or individual looking to reduce your currency risk and remove a certain level of uncertainty from your future currency transactions there are a number of tools that you can use to help you achieve this. A reputable currency broker will be able to guide you through various methods such as hedging, stop loss orders and forward contracts which can all help you to reduce your exposure to foreign exchange risk.

What is foreign exchange hedging?

A currency hedge is a type of financial instrument known as a derivative that derives its value from an underlying asset. The most common forms of hedging strategies used for currency transactions are options and forwards. An option allows you to set the exchange rate at which you wish to carry out your currency transaction. A forward contract allows you to agree on a specific exchange rate for a set date up to two years in the future.

Foreign exchange hedging allows you to manage your foreign exchange risk from adverse currency movements. These adverse movements will affect the amount of currency that you are able to buy or sell. You cannot completely eliminate currency risk but foreign exchange hedging facilities will enable you to greatly reduce your risk.

The opportunity cost of currency hedging strategies

We have discussed the advantages of using foreign exchange hedging strategies, it is also important to highlight the opportunity cost of using such methods. Legally binding forward contracts and orders enable you to remove uncertainty and know the exact cost of your currency transaction. However what these contracts also do is lock you into an exchange rate and prevent you from taking advantage of higher exchange rates should the currency market move in a favourable direction. Although this is a negative aspect it is also worth remembering that as easily as the markets moving to your advantage they could easily move in the opposite direction and end up costing you a lot more money. With a currency hedging strategy you will be able to reduce your foreign exchange risk.

Article Summary
by Oliver Kingston  - Senior FX Consultant at Compare Currency

If you are looking to carry out a currency transaction over £5,000 then exchange rate risk will be a factor you will need to research thoroughly.

I have seen so many people (large companies too) walk into this subject thinking they ‘will be alright’ .. things will work out fine. Quite often, people lose thousands with this attitude.

My advice – The currency markets move 24/7. There are literally hundreds of factors moving the markets within 1 single trading day. Think you can learn all this and keep your day job? It’s very difficult. Over the past ten years of consulting for corporate clients, it never ceases to amaze me how shocked people are by the intra-day movements in the currency world.

People often think they can manually keep ahead of the market? Whilst you sleep? Whilst you are working?

Lets look at a practical example to illustrate this.

I’ve just looked up some recent data to illustrate what sort of things can happen .. Lets say 11th Jan 2011 you enter into a US$ based property sale (personal) or a business agreement to sell widgets to an American company. The rate at the time would be circa 1.5600 (probably more like 1.52 if you used a high street bank). OK, so you do your maths. You work out that $250,000 at that rate would be £160,256.

You carry on with your busy life, checking ceefax from time to time, wishing that the rate is going to fall.

Then the reality kicks in towards the end of January. Rates are rising and you are contracted to the sale agreement. You panic last minute. You ring around to try and get better rates. You can always get better rates but the underlying currency rate has now moved much further than you had anticipated.

It is now the 02nd Feb and the conversion rate is now 1.6187. Your $250,000 is now worth £154,444. You just lost nearly £6k in 3 weeks. This happens more than you would like to imagine.

These are real figures from the past month. This kind of movement happens every month in nearly every currency pair.

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