This checklist describes how hedging can reduce a company’s exposure to risk from foreign exchange fluctuations.
A company that imports raw materials, exports finished goods, or has overseas assets or subsidiaries is exposed to fluctuations in exchange rates. Adverse movements can wipe out export profits, while positive changes can increase the price of its products in the foreign market. Equally, the company could benefit from windfall profits as a result of exchange rate fluctuations.
A company trading across national borders therefore has a number of choices. It can take a chance with spot rates, buying currency when required. This leaves it totally at the mercy of exchange rates. The risk can be removed if it books a forward exchange contract that fixes the rate for the date on which it will be needed for a transaction. If the rate improves, however, the company will not be able to take advantage of the improvement.
Using a combination of flexible products allows the company to protect itself against adverse movements while still giving it the ability to profit from improvements. A wide variety of instruments are available that allow companies to pursue this strategy. Which is chosen depends partly on the level of risk and also on the ease of converting the currencies.
The Participating Forward
This product is similar to a forward exchange contract in that it limits risk by offering a worst-case exchange rate for a transaction. If, however, there is a favorable move in exchange rates, the company can take advantage—generally with half its currency. There is usually no premium payable for this product.
A company imports Cava wine from Spain to the United Kingdom. It is April, and a supplier has to be paid €4 million in October in time to catch the Christmas market.
The forward rate is 1.2100, and the company wants the certainty of a worst-case rate but doesn’t want to lose out if the rate goes up. The foreign exchange broker offers a rate of 1.1800, with the option to buy half the currency on the spot market two days before completion of the transaction.
Sterling strengthens against the euro and the rate rises to 1.2500. The customer pays £1,694,915 for the first €2,000,000 at the low rate agreed in advance and £1,600,000 for the second €2,000,000 at the spot rate. The average rate is therefore 1.2150, slightly better than the forward rate, but not as good as the spot rate.
Alternatively, the euro strengthens against sterling and the spot rate is 1.1600. The company then pays the rate of 1.1800 for the whole transaction.
The advantages of a participating forward are: a guaranteed worst-case rate; total protection against currency falls; a partial benefit from currency gains; and no premium. The disadvantages are: if the currency weakens the rate will not be as good as a forward exchange contract; and the spot rate will be better if there is a positive move in currency.
The Protection Option
With this service a company pays a premium for an option to exchange currency on a fixed forward date at a predetermined rate. If the spot rate on that date is better than the predetermined rate, the company can decide not to exercise its option to sell at the predetermined rate.
A UK company is selling dresses to a customer in the United States. In six months it will receive US$4,000,000. The current forward rate for this date is 2.0000. Fearing that sterling is going to strengthen against the dollar, the company opts to buy a protection option at the forward rate.
Sterling does strengthen against the dollar, taking the rate to 2.1500. The company then exercises its right to sell dollars at 2.0000.
The dollar strengthens against sterling. The rate is now 1.8500. The company takes the better rate on the spot market.
The advantages of the protection option are: a guaranteed worst-case rate; total protection against negative currency fluctuations; and the ability to take full advantage of positive currency movements. The disadvantage is that a premium is payable to the foreign exchange trader.
Other Hedging Products
There are many other ways for companies to hedge against currency variations using derivatives. Currency markets are extremely volatile, and it makes sense for any organization trading across national borders to protect itself from these fluctuations.