What it means
Any business that pays or receives money in a foreign currency is exposed to exchange rate changes. A US firm that has agreed to pay a supplier 500,000 euros in three months does not know what that will cost in dollars until the day it pays.
The most common hedging tools are forward contracts, options, swaps and natural hedges. A forward fixes the rate for a future date, an option gives the right but not the obligation to trade at a set rate, a swap exchanges cash flows in different currencies, and a natural hedge matches income and costs in the same currency.
A hedging strategy begins with identifying exposures. These include transaction exposure (invoices and payments already agreed), translation exposure (foreign subsidiaries' results converted to the reporting currency) and economic exposure (the long-term effect of currency moves on competitiveness).
The policy then sets how much to hedge, commonly a percentage of forecast exposure that falls as the time horizon lengthens. For example, a company might cover 100% of confirmed invoices, 70% of expected flows within three months and 30% of flows further out.
Hedging has a cost, either an explicit fee or the opportunity cost of giving up a favourable move. A forward removes both the risk of loss and the chance of gain, so it is normally judged by how well it stabilises results, not by whether it beat the market.
Good governance matters as much as the tools. The board should approve the policy, the finance team should report on hedges regularly, and speculation should be explicitly prohibited.
In practice
Real-world examples.
Example
A UK software company invoices US customers in dollars. It enters forward contracts to sell the dollars it expects to receive, so its sterling revenue is known when the budget is set. The contracts mature on the same dates as customer payments are expected.
Example
A US exporter uses a natural hedge by buying components from a supplier in the same currency in which it sells its products. The foreign currency revenue and costs offset each other, and only the net amount needs a financial hedge. This cuts the cost of hedging because fewer contracts are needed.
Example
An investment fund holds European shares and does not want currency moves to affect returns. It sells euros forward each month to hedge the value of the portfolio. The cost or benefit of the forward rate is reported separately from the performance of the shares.
Formula
Calculation
Hedged cost = foreign amount x forward rate
Unhedged cost = foreign amount x spot rate at payment
Suppose a US importer owes 500,000 euros in three months. The spot rate today is 1.1000 and the three-month forward rate is 1.1100, so a forward locks in a cost of 500,000 x 1.1100 = $555,000.
If the spot rate at payment is 1.1500, an unhedged payment would cost 500,000 x 1.1500 = $575,000, so the hedge saves $20,000. If the spot rate were 1.0500, an unhedged payment would cost 500,000 x 1.0500 = $525,000, and the hedge costs $30,000 more than doing nothing, which is the price of certainty.Case study
Seen in the real world.
Brightpath Furniture is an illustrative, fictional US retailer that imports 80% of its stock from Italy. For several years it left currency exposure unhedged, and one year a sharp rise in the euro cut its gross margin by 4 percentage points.
The new finance director introduced a hedging policy approved by the board. It required 100% cover on confirmed purchase orders and 50% on forecast orders for the next six months, using forward contracts, with monthly reporting.
In this illustrative case, margins became more stable and the sales team could set catalogue prices with confidence. The finance director also reported honestly that the forwards sometimes cost more than the spot rate, explaining that this was the price of removing the surprise. The board accepted that view and kept the policy unchanged.
Watch out
Common mistakes.
- Judging a hedge by whether it made money, when its purpose is to reduce uncertainty.
- Hedging more than the real exposure, which turns the hedge into speculation.
- Having no written policy, when decisions made case by case tend to be driven by hindsight and emotion. A clear policy also protects the finance team from being blamed for the market's moves.
Questions
People also ask.
What is a natural hedge?
It is when a business matches foreign currency income with foreign currency costs, so that exchange rate moves partly cancel out without any financial contract.
Should a business hedge everything?
Not necessarily, as many set a target percentage, hedge more of the near-term certain exposures and less of the distant uncertain ones.
Does hedging remove all currency risk?
No, it reduces it but leaves residual risks, such as counterparty risk and the risk that forecast volumes turn out to be wrong. A company that over-hedges a sale that never happens can end up with a loss on the contract and no underlying income to offset it.
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