Understanding Currency Hedging: Strategies, Meaning, and Examples

Introduction

While Insurance is a sure way of providing you with an extra layer of protection from any unforeseen event, currency hedging is an attempt to minimize the impact of foreign currency risk on investment returns.

If you invest or engage in business internationally, you must explore currency hedging strategies. To hedge an investment, investment managers need to set up a related currency investment strategy to offset changes in the value of foreign currency. Simply put, currency hedging reduces the risk of an investment due to fluctuations in the foreign exchange (FX) rate.

What is Currency Hedging?

Currency hedging involves using financial instruments to counteract potential losses from the rate changes. It is used to lower the risk of fluctuating FX rates. For this, the company creates a forward contract with an investment dealer to sell off currency at a future date at today’s FX rate.

How does currency hedging work?

Hedging currency risk aims to reduce the unpredictability of equity investments and provide a measure of risk control by enabling investors to isolate currency risk from their equity asset allocation. Before hedging currency risk, companies need to determine the degree of forex risk they can take.

When companies conduct business across borders, they deal in foreign currencies. This makes them prone to forex risk when they exchange foreign currencies for home currencies. This is exactly where foreign exchange risk awareness comes into play.

For example, let’s say a family from Mexico planning a trip to the US. They need to exchange their Pesos for US dollars to cover expenses. However, if the Peso weakens against the dollar during their trip, they may end up spending more than budgeted. Hedging currency risk helps them secure a fixed exchange rate in advance, shielding them from unexpected fluctuations.

Foreign currency hedging involves employing either a cash flow hedge or a fair value hedge. Fair value hedges aim to minimize the impact of fluctuations in asset fair market values. On the other hand, cash flow hedges help manage risks stemming from sudden changes in asset or liability cash flows.

Aspect	Cash Flow Hedging	Fair Value Hedging
Objective	Minimize risks associated with fluctuations in cash flows of assets or liabilities	Reduce risks related to changes in fair market values of assets
Primary Focus	Protect against variability in future cash flows	Shield against changes in the fair value of assets
Timing of Recognition	Hedging profits or losses recognized in the same period as the hedged cash flows	Hedging profits or losses recognized in the income statement
Financial Instruments	Typically involves forward contracts, options, or swaps	Often employs derivatives like futures contracts, options, or swaps
Accounting Treatment	Hedge effectiveness tested at inception and periodically thereafter	Hedge effectiveness tested at inception and each reporting period
Applicability	Suitable for managing risks related to forecasted transactions or firm commitments	Appropriate for hedging risks associated with recognized assets or liabilities
Impact on Income	May result in increased income volatility	Can lead to more stable income fluctuations

Key Considerations Before Currency Hedging

The complexities of currency hedging require a thoughtful approach clubbed with a thorough assessment and strategic planning. Before diving in, it is essential for you to carefully consider several key factors. By evaluating your currency risk exposure, defining clear objectives, and understanding market dynamics, you can develop a practical currency hedging strategy tailored to your business needs. Let’s explore some critical considerations to guide your decision-making process.

1. Predicting the timing of currency movements can be challenging

   
   

   Because currency may move in waves, trending one way or another, it can significantly impact your investment decisions in the long run. Predicting which way it will go, especiallyin the short term, can be challenging. 

   
   

   

   
   

2. Foreign currency adds volatility and can be expensive

   
   

   A portfolio’s average annual returns are not the full story; they are a part of the story. Here’s an example for you to comprehend it better.

   
   

   Investors John and Sarah both invest $100,000 in the stock market. John chooses a portfolio with high volatility, while Sarah opts for a more stable, low-volatility portfolio. Over the next few years, both portfolios experience average annual returns of 8%. However, due to the volatile nature of John’s portfolio, its value fluctuates significantly each year. In contrast, Sarah’s portfolio maintains a steadier growth trajectory. After five years, John’s portfolio is worth $155,000, while Sarah’s portfolio has grown to $146,000. Despite the same average returns, the impact of volatility is evident in the final portfolio values.

   
   

   

   
   

   Over the years, while exchange rates fluctuate annually, their impact on investment returns tends to lessen. Long-term investment horizons allow short-term currency movements to smooth out, enabling underlying fundamentals to play a more substantial role in returns. This underscores the value of patience and strategic planning in managing currency dynamics within investment portfolios.

   
   

5 Best Currency Hedging Strategies

Here are 5 effective business strategies for hedging foreign currency risk:

1. Opt for a forward contract
2. Opt for a future contract
3. Opt for currency swap hedging
4. Use a currency option
5. Invest in Hedged Foreign Bond Funds (ETFs and Mutual Funds)

• Opt for a forward contract

  
  

  You can effectively reduce the effect of foreign exchange risk (FX risk) through the use of forward contracts. This currency hedging strategy involves purchasing a specified foreign currency at a set or pre-agreed exchange rate on a future date.

  
  

  By picking this option, you can secure the current exchange rate and safeguard yourself against losses if the value of the foreign currency decreases. Businesses like yours need to keep in mind, however, that if the value of the foreign currency rises, a forward contract could result in a loss.

  
  
  
  

  Example of a forward contract

  
  

  For example, you can use a forward contract if you’re based in Europe but conduct business in the US. This currency hedging example will only come into play if the value of the US dollar drops relative to the Euro (not the other way around).

  
  
  
  

• Opt for a future contract

  
  

  A future contract is very similar to a forward contract. These two currency hedging methods include buying or selling currency at a specified price and date to hedge foreign currency exposure.

  
  

  Forward contracts are private, customizable, and traded directly between two parties, while futures contracts are standardized and traded on exchanges. The future contracts, however, follow compliance and are usually updated with regulatory norms. This makes it less risky for the counterparty. Hence, it is safer to hedge against foreign currency volatility via this option.

  
  
  
  

  Example of a future contract

  
  

  For example, a maize farmer expects to harvest 5000 bushels in three months. To lock in a price, they enter a future contract to sell 5000 bushels at $5/bushel. Regardless of market fluctuations, they’re guaranteed this price at harvest, shielding them from potential losses due to price drops.

  
  
  
  

• Opt for currency swap hedging

  
  

  Currency swap hedging is an effective risk management technique that includes exchanging interest payments and principal amounts in two different currencies. The major benefit of this currency hedging method is that swaps are often used to hedge against exchange rate volatility and to borrow at a lower interest rate in a foreign fund currency.

  
  

• Use a currency option

  
  

  Currency options are the most common type of currency hedging that helps individuals, businesses, and financial institutions protect themselves against foreign exchange risk. This gives the buyer the right (but not the responsibility) to buy or sell a specific currency at a pre-decided exchange rate on or before a set date. This is followed by a premium paid to the seller. 

  
  

  

  
  

• Invest in hedged foreign fund bonds

  
  

  Ever wondered what it would be like to put your money into currency-hedged Exchange Traded Funds (ETFs) and mutual funds and also practice hedging currency exposure? All this, regardless of the market conditions, – best, right?

  
  

  As a smart investor, you should try to reduce your portfolio volatility and hedge foreign currency exposure by investing in reliable foreign bonds.

  
  

  For example, in a report by Kenneth A. Orchard, Head of International Fixed Income at T. Rowe Price, an investor who is looking at an emerging market local currency bond with a much higher yield and greater volatility than U.S. Treasuries, seeks to buy 100,000 South African bonds maturing on March 31, 2032, yielding 10.79% for 85.35, would need ZAR 85,346 or USD 5,009. Assuming the investor wants to hedge all the bond exposure back to U.S. dollars, they will be able to sell the South African rand forward 12 months at an implied yield of 7.83% and effectively receive USD SOFR of 4.87% for a net cost of hedging of 2.96%. 

  
  

Given that the yield the investor receives from owning the bond is 10.79%, the effective hedged yield is 7.83% (10.79% less 2.96%). Equivalent U.S. Treasury bonds maturing in December 2032 were yielding 3.87% on December 31, 2022. In this case, the hedged bond yields less than the unhedged bond but has much less volatility and is still greater than the U.S. Treasury bond.

Why is Currency Hedging Important?

Currency hedging strategies are a great idea if you deal with businesses internationally. Currency hedging lowers your chances of risk exposure and makes it easier for you to conduct business and invest across borders. It is crucial to choose the right hedging strategy at the right time to see results.

However, this isn’t always a cakewalk, as foreign fund hedging can be risky. This is because it is difficult to predict currency movements and can prove detrimental to your business/investments. In a nutshell, currency hedging costs can be huge, and the process is often lengthy and complicated. 

10 Currency Hedging Strategies to Lower Risk

Before investing in a mutual fund with foreign currency exposure, investors should consider their appetite for currency risk. It may be suitable for some investors to remain unhedged, while it may not be suitable for others. Here are some general guidelines for hedging currency risk:

How HighRadius’ Cash Forecasting Software Can Help You with Currency Hedging 

HighRadius Cash Forecasting helps businesses make data-driven decisions based on accurate future cash predictions. Here’s what it can do for your business.

1. Seamless Data Integration and Aggregation: This cash forecasting software can integrate with various financial systems, such as ERP systems, bank accounts, and other relevant data sources to gather real-time cash flow data with a 100% automated bank integration feature.
2. Historical Analysis: This software can analyze historical cash flow data to identify patterns, trends, and seasonality and provide insights into how cash is typically generated and spent over time. This improves the global inflow and outflow forecast accuracy by 95%.
3. Accurate Cash Forecasting: The system uses machine learning algorithms, capturing variables such as customer payment behavior, invoice data, purchase orders, and economic indicators to generate accurate forecasts. It also enables the use of custom-based models for different cash flow categories (Heuristic models for payroll and taxes forecasting and AI models for A/R and A/P forecasting) forbuilding accuracy up to 95%.
   

   This helps businesses to become aware of their risks beforehand and pick an effective currency hedging strategy that assists them in battling FX rate fluctuations.

   
   
4. Scenario Planning: HighRadius Cash Forecasting Software allows users to create multiple scenarios based on different assumptions or business situations. This feature enables organizations to evaluate the impact of various factors on cash flow, such as changes in sales volume, payment terms, or supplier relationships. Overall, this feature helps increase forecasting productivity by 70%.
5. Visualization and Reporting: It offers interactive dashboards and reports visually representing cash flow data. This enhances understanding of cash flow patterns and facilitates effective communication of financial insights across the organization. With this, you can plan in advance and reduce idle cash by 50%.

FAQs

1) What are the factors to consider before hedging currency?

Before hedging currency, you need to evaluate exposure levels, risk tolerance, and market trends. Consider hedging costs, available instruments, and time horizons. Assess counterparty risk, regulatory compliance, and accounting implications and align strategies with business goals and evolving risk profiles.

2) What is the purpose of hedging a currency transaction?

The purpose of hedging a foreign currency transaction is to eliminate the risk of adverse exchange rate fluctuations, preserving the value of assets, liabilities, revenues, or expenses denominated in foreign currencies. It aims to stabilize cash flows and protect against potential financial losses.

3) How do currency hedged funds work?

Currency-hedged funds use financial derivatives to offset the impact of currency fluctuations globally. By using hedging methods like forward contracts or currency swaps, these funds aim to eliminate or reduce the currency risk associated with holding foreign assets, thus providing more stable returns.