Foreign Currency Hedging Guide – How to Buy and Use FX Hedging

Whether you are an individual in London who wants to purchase property overseas in different currency or a multinational business which collects foreign currency and pays with foreign currency, foreign currency hedging can prove vital and effortless. Join us on our journey at MoneyTransferComparison to learn more about FX hedging. We’ll explain what a foreign currency hedge is, the different types of foreign exchange derivatives and foreign currency contracts that can be used when hedging forex, and what foreign exchange hedging for businesses actually looks like.

This foreign exchange hedging guide was written by Badre Bouarich, a former Trader and Multi Asset Structurer (Forex, Interest Rates) at HSBC bank in London & an expert Financial Writer.


Best Foreign Currency Hedging Specialists

How to choose your fx hedging provider? what should you be looking for?

Min 10 years in the business
Most hedging options
Dedicated corporate FX departments
Best foreign exchange rates for deriviatives
Most global offices
Highest level of satisfaction by corporate / large clients

Top 3 for Foreign Exchange Hedge

  • Min Transfer: £/€/$100
  • Currencies Supported: 39
  • Offices : UK, EU, USA, India, and South Africa.
  • Our Rating : 97.8%
  • Serving Clients Since 1996

    94% Positive Client Reviews

    Spot, Forward, Market Orders, Currency Options and Treasury Management.
  • Min Transfer: £/€/ 1,000
  • Currencies Supported: 138
  • Offices : UK, Cyprus, and South Africa.
  • Our Rating : 90.6%
  • Easy Sign Up Process

    Friendly, Welcoming Service

    Forward Contracts, Limit Orders, and a Wide Array of Options
WorldFirst Logo
  • Min Transfer: £/€ 1,000
  • Currencies Supported: 121
  • Offices : UK, EU, Australia, HK, Singapore. USA Clients not Accepted
  • Our Rating : 95.4%
  • 8bn in Annual Turnover

    0.15% to 0.5% in FX Margins

    Forward and Limit Options Available

For starters, our FX hedge comparison consisted of listing the best companies for buying foreign exchange derivatives and currency hedging tools. While some business money transfer providers such as Moneycorp and Currency Solutions, provide a wide range of fx hedging options, others limit themselves to the simplest tools or simply  spot FX transactions. In our opinion, the companies listed above represent the best balance between service and offerings for the purpose of FX hedging.

New: Learn how to create a hedging guide for extreme FX volatility, as caused by the COVID-19 crisis this year.

Forward Contracts – Currency Hedge 101

Provided by most FX companies

This constitutes the simplest foreign exchange hedging instrument and it is provided by almost all foreign exchange brokers. As one of the most common foreign exchange contracts it is an agreement between you and a counterparty that consists of exchanging a certain amount of a given currency at a specified time in the future, for a predetermined rate. As an example, let’s say you are a British citizen looking to buy a property in the US next year.You could enter into a 1 year forward contract where you sell British pounds to buy $300,000 at 1.54. By entering into this transaction, you  remove any type of uncertainty related to the cost of the house. After your year is up and you reach the maturity date on your forward contract, you would pay £194,805 and get $300,000 – which will be used for the acquisition of the house.

The agreed upon forward rate in foreign exchange contracts is usually linked to interest rate differentials between the currencies involved. Without getting into technical details, the forward curve can be upward or downward sloping. In other words, there are cases where the 1 year forward rate would be better than the current spot rate (which enables you to gain on the hedge) and there are cases where the 1 year forward rate would be worse (therefore, the hedge would have a cost). 

Regarding the FX hedge, there are many FX houses that enable the use of forward contracts as an FX hedging tool. , Others (such as our recommended companies lower on this page) offer more advanced options for hedging forex.

forwardcontractsgraph

Pros

  • Simple Exchange Rate Hedging Instrument
  • Liquid instrument especially on short maturities
  • Total  FX Hedge
  • Positive Carry when the forward rate is better than the spot rate

Cons

  • Negative Carry when the forward rate is less attractive
  • Inability to capture a favourable market movement

Learn more about its pricing: Currency Forward Contract Pricing.

When to use such instruments in your fx hedging strategy?

If you just want to remove any type of fx related risk, then a forward is the foreign exchange contract for yout. As a total FX hedge (i.e. guaranteeing today’s exchange rate for a point in the future) it will remove all exchange rate risk, and help to remove the worries and stress of the rate moving against you. This being said, if you are convinced that the GBPUSD rate will move in a favourable manner (increase), then entering into a forward might not be the best option. You may prefer some of the other hedge types we list below.

Forward contracts aren’t just for one-off payments either. As an example, you may take a  loan in a foreign currency (and loan repayments are made in the same currency), while your business/individual income is made in your local currency. Foreign exchange brokers will allow you to book multiple forwards for each loan repayment you have to make in a foreign currency. This can be especially helpful with unsecured loans, where it is highly recommended not to miss out on your loan repayments, so it is best not to rely on luck and suffer/gain from the currencies volatility, as they fluctuate.

Did You Know? In order to lock today’s exchange rate for the future – you will have to place a down payment of 10% of the value of your foreign exchange contract. The only exception to this is with Moneycorp which allows established businesses to book a forward contract without paying any sum upfront. Read more on our Moneycorp review.

Did you Know? There is another “type” of forward named an FX Swap. As far as hedge types go, it performs a slightly different type of FX hedge that’s suitable when you know you will require your base currency again in the future. If you want to read more about Forward Vs. Swap go here.

Limit Orders

Another way of hedging forex is with automatically executed limit orders. Let’s say that the current GBPUSD exchange rate is 1.56. However, you seek to get an even better rate without locking yourself into a forward transaction. Basically, you could set a limit order and ask your dedicated dealer to execute the transaction whenever the GBPUSD rate reaches 1.60. At that moment, you would buy $300,000 and sell £ 187,500.

Pros

  • You have the possibility to get the rate that you want
  • No need for you to track things, the foreign exchange contract is  automatically triggered

Cons

  • No foreign currency hedge if the target rate is not reached
  • Your upside potential is limited as you can not fully capture favorable market movements above your limit order

limit-orders-graph

When to use the instrument?

Given its pros and cons, you should use this instrument if you expect the market to move in a favorable manner over the short term, before going against you later. Let’s say the current GBPUSD rate is at 1.56. If you think the rate would go up to 1.59 before going down to 1.50, you could set a limit order at around 1.5850.  At that rate and in this example, your transaction will get executed and your  exchange rate hedging  would see you maximize your profit on the trade.

However, this is just an example and it is never guaranteed your limit order will be met. If you set your limit order unrealistically high then there is almost no FX hedge there in the first place. You should never set a limit order which is too far from the spot rate. We advise to set a maximum difference of 1.5 big figures. In the current example, it would mean setting a limit order at 1.5750.

Learn more about FX limit orders here.

Stop Loss Order

Of all the hedge types, this one is perhaps most useful if you want an FX hedge that protects you  against negative market movements, while still retaining the possibility to trade should the rate move in your favour. Let’s say the current GBPUSD is at 1.56 and you want to be able to gain if the rate goes up but protect yourself should it fall below a certain exchange rate. For example you know that if the exchange rate falls below 1.54 you will not have enough cash to buy your property overseas, so the foreign currency hedge or stop loss order automatically buys USD if the rate moves down to 1.54. The trade has been executed in your ‘worse case’ scenario. 

Pros

  • Exchange rate hedging for negative market movements
  • You retain an upside potential
  • Less worries and more possibilities

Cons

  • Can lock you in a yoyo market.
  • Will not benefit if the rate moves in your favour after it has fallen to the stop loss order

stoplossgraph

When to use this type of FX hedge?

The stop loss order is great at enabling you to hedge risks while keeping the upside open and allowing you to capitalize on favorable fx movements. However, at times the tool can be tricky. Let’s assume that the current exchange rate is at 1.56 and you set a stop loss at 1.54. Imagine that the USDGDP goes briefly down to 1.54 before skyrocketing to 1.60. Basically, the stop loss would have triggered and your transaction would get executed at the worst rate.

This form of foreign exchange hedging is perhaps best used  whenever markets seem to be directional and move without yoyo noise. We advise you to set the stop loss at least 2 big figures away from the current spot rate. Or if there is an exchange rate you absolutely know you can’t go below.

One Cancels Other Order (FX Hedge with Upside Potential)

This is a combination of both limit and stop loss orders. When combined, the two tools can provide you with a near-complete foreign currency hedge.  If using  our example the exchange rate hedging would see you set a stop loss at 1.54 and a limit order at 1.58. Whenever either of these rates are reached, the transaction will get executed at that rate. Basically, this would enable you to create an FX hedge against wide market movements while keeping an upside potential (limited though).

As the graph suggests, this kind of order provides a foreign currency hedge against severe volatility and enables the customer to keep some upside potential.

Pros

  • Limited Risk
  • Upside Potential
  • Limit or Stop Loss Order will be automatically triggered if the rate is met

Cons

  • Limited Upside Potential
  • Yoyo moves can drive both gains and losses – with little volatility may not trigger for a long time

onedealcancelsothergraph

When to use the instrument?

In cases where you have no idea where the rates will go and when you need an FX hedge that retains some upside potential, this order can be quite helpful. It will limit your profit & loss potential and provide a foreign currency hedge for your exposure. If you don’t provide enough buffer in your orders, then yoyo market moves can lead you to quickly locking in a rate that does not correspond to the currency movement’s real tendency/, though ultimately  it should provide an FX hedge against your worst case scenario.

Setting up both hedge types (stop loss and limit order)  at the same time is certainly possible although clients usually just opt for one, depending on what is most important to them. Remember you can also implement rate alerts to be notified if a target rate is met – just be aware the onus is on you to make the trade in this scenario as a rate alert doesn’t automatically execute the trade in the same way a stop loss or limit order doe

Less Common Tools For Currency Hedging:

1. Time Option (Flexible Settlement)

A time option is a type of FX hedging that enables you to settle forward transactions between two pre agreed upon dates in the future. Let’s say that you are unsure about the exact acquisition date of your property in the United States, this option gives you flexibility as to the execution date of the transaction. The forward rate will be the same and it will usually not involve any premium payment.

Read more about FX options here.

2. Option Structures

Options, also known as foreign exchange derivatives, are a much more flexible solution compared to a forward contract. The forward contract provides a complete exchange rate hedge in the market by locking in today’s rate for the future. Foreign exchange derivatives or options provide you with exactly as the name suggests – the option to buy / sell a currency should certain rate movements or parameters unfold. Basically, any kind of forward could be replicated by the use of options. Options are foreign exchange contracts that whether bought or sold, enable clients to achieve a particular financial objective. They aren’t particularly common for private individuals but when it comes foreign exchange hedging for businesses, they are more likely to require the flexibility an option can provide.

Read more about FX options here.

3. Call Options

optionsstructuregraph

A call option is one of the more vanilla foreign exchange derivatives. It is an agreement to buy an asset some time in the future and at a predetermined cost. As an example, a GBPUSD 1 year call option with strike 1.54 enables you to buy GBP and Sell USD in 1 year time at a rate of 1.54. Obviously, at that time, should the spot rate be higher than the strike, you would exercise the option and buy at the strike rate. Should the spot rate be lower than the strike, then you would ignore the option and directly buy in the market. 

Obviously one pays a premium in order to have the possibility to enjoy such a possibility. In the case above, the lower the strike rate, the higher the premium of the call option will be.

Read more about FX options here.

4. Put Options

putoptiongraph

Inversely, the foreign exchange derivative known as a put option agreement gives the possibility to sell an asset at a pre-agreed upon strike rate. As an example, a GBPUSD 1 year put option with strike 1.54 enables you to sell GBP and buy USD in 1 year time at a rate of 1.54. If at that time, the spot rate is lower than the strike, you would exercise the option and make money. In the opposite case, you would just ignore the option and sell at the market spot rate.

You would buy a put option if you need to sell an asset in the future and want to hedge against a depreciation of that asset. Inversely, you would sell it in case you expect the asset price to go up and want to monetize the option’s premium.

Read more about FX options here.

5. Participating Currency Forward

As far as FX hedging goes, a participating forward is similar to a forward except that you keep some upside potential by diminishing the notional of the short option. In our case, you buy a put option on GBPUSD with a notional of $300,000 and you sell a call option of the same currency pair with a notional of $150,000.

In this case, imagine the GBPUSD rate goes to 1.58. You would make fx gains and you would pay half the gains you made to the call option buyer (Half Notional of $150,000). In the same case, should the rate go down to 1.50, you would make losses on the transaction, though the put option seller would pay you any loss on the full notional ($300,000). Overall you will have a foreign currency hedge below the strike rate (1.54), and you will be able to make gains above it.

 Pros

  •  Downside Risk Hedged
  • Upside Potential
  • No Execution related worries

Cons

  • Premium to be paid or incurred through worse strike rate

Without getting into advanced technical details, there are countless instruments that make use of a combination of option contracts when hedging forex. These can mitigate particular exposures and/or capture possibilities. We welcome you to read more on our FX options guide for more information on foreign exchange derivatives when conducting foreign exchange hedging for SMEs or individuals.

 

Having gone through call and put options, let’s have a look at potentially useful structures using a combination of these instruments.

Best Foreign Currency Hedge Combinations

An alternative way of looking at a  forward contract is that it can be seen as a combination of options. One could replicate a short GBPUSD forward by selling a call option and buying a put option of similar notional, strike rate and maturity. Your FX hedge will be achieving the same thing.

To make things simpler look at it this way: you give up a gain in order to mitigate a loss. When the GBPUSD rate goes above the strike rate (let’s assume 1.54), you give up all the gains to the call option buyer. At the opposite, when the GBPUSD rate goes below that rate, you receive money from the put option seller in order to mitigate your losses. 

At the end of the day, you have an FX hedgeat the rate of 1.54 (which is an example). Usually, the replication of a forward contract using options will not involve any premium payment when the strike rate is equal to the market forward rate.

Another excellent way of mitigating currency via a natural hedge is keeping the business’ reserves in multiple currencies; multi-currency accounts for businesses can assist in doing that.

Preparation

 

How will you know what is the best time to seek foreign exchange hedging? You can obviously sign up with the money transfer companies recommended on this site, and be passive i.e. ask them to follow the rates of the currencies you deal with, and contact you upon large swings.

Another possibility, if you are exploring foreign exchange hedging for businesses or yourself, is to be involved to a certain degree with the world’s economy. You can go here to learn about economic factors that impact currencies (or the LIBOR), learn about major historical events from the past that had a tremendous impact on currencies, and be in tune with our economic calendar of big announcements planned in the coming year. Of course, you need to keep up with the recent currency news. Foreign exchange hedging is as much about understanding the market you operate in as it is choosing the most relevant solution.

 

Conclusion – Foreign Exchange Hedging for Businesses

At a time where market volatility makes a great impact on individuals’ and businesses’ budgets, it has become essential to planahead carefully. Foreign exchange hedging can provide much more protection to you or your business than being at the mercy of spot rates but depending on the hedge types you choose and the rates you are looking to achieve, you have to be aware there is a chance for downside too. While some would consider technical proficiency as a sign of performance, others would see simplicity as the ultimate sophistication.

At money transfer comparison.com, we believe that not only it is essential to conduct FX hedging and mitigate risks, but it is even more essential to understand what one is doing. In this regard, we advise our clients to hedge using simple instruments:

  • Vanilla Forwards (Normal Forward)
  • Limit Orders
  • Stop Loss Orders

We also recommend our clients only deal with the most technical companies when considering the use of these products, particularly foreign exchange derivatives. Given our performed assessments, along with customers’ feedback, you would get great guidance and advice by buying FX hedging products through MoneyCorp and Currency Solutions or other leading companies in theforeign exchange hedging for SMEs space.

Below you can find a finite list of all the companies we covered which offer foreign exchange hedging functions for private clients and SMEs.

  1. Currencies Direct Review
  2. World First Money Transfer Review
  3. TorFx Review
  4.  Moneycorp Review
  5. Currency Solutions Review
  6. Global Reach Review
  7. OFX Money Transfer Review
  8. Kantox Money Transfer Review
  9. Key Currency Money Transfer Review
  10. Privalgo Money Transfer Review
  11. Smart Currency Exchange Review
  12. PureFX Money Transfer Review
  13. Currencies.co.uk Money Transfer Review
  14. XE Money Transfer Review (XE.COM)
  15. Voltrex FX (VFX) Money Transfer Review
  16. EasyFX Money Transfer Review
  17. Halo Financial Money Transfer Review
  18. Afex Money Transfer Review
  19. AxiaFX Money Transfer Review
  20. SendFX Review
  21. Transfermate Money Transfer Review
  22. Frontierpay Money Transfer Review
  23. FinGlobal Forex Review

 

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Dan Ferguson
5 years ago

Thank you, helped me refine concept I was only slightly familiar with.

5 Factors in Deciding Between Domestic & Overseas Loans | FintechLab
4 years ago

[…] the fluctuations in exchange rates can heavily impact your repayment, and it is advisable to use derivatives like Forward Contracts to fix the rates. Buying a Forward has costs of its own which should be factored into the […]