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

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.

The Five Pillars of a Successful Currency Hedging Strategy

Whilst one company’s hedging strategy will look different to the next, it is important to review the five key pillars to determine the most appropriate solution for you.

  1. Identify: Before taking any action, it’s imperative to identify the extent of your company’s exposure to currency market movements. How many positions do you currently hold in the currency market? How frequently do you need to make international payments, are they regular and what size are they? Do you have to occasionally make larger payments?
  2. Define Objects: By beginning to understand how much exposure you will have throughout 2020 you can then establish the potential impact of exchange rate shifts on your cash flow and define your objectives. How much risk are you looking to mitigate and at what cost?
  3. Strategy: Once you’ve identified your objectives, you can then discuss your business requirements with international money transfer and currency specialists. Talking through the various options will help you ascertain how much of your currency exposure you want to hedge and the most appropriate FX products to achieve this. These tools should ultimately help to protect your profit. Consultations are free and there are certainly no obligations to go on and trade with a particular currency specialist.
  4. Review: Once you’ve implemented your strategy it should be monitored closely and reassessed on a periodic basis to make sure it’s performing optimally.
  5. Discover: Use the right hedging provider to get the best rates and closest guidance.

Top 3 for Foreign Exchange Hedge

moneycorp
  • Supported Currencies: 120.
  • Clients From: Globally with offices in UK, USA, France, Spain, Ireland, Australia, HK, UAE, Brazil, Gibraltar and Romania.
  • Authorised? Yes, by the FCA.
  • Guidance / Dedicated Dealer: Yes.
  • Online System: Yes, including an app.
  • Strong Point: Credibility, Reputation, Liquidity, Level of Service, Best Credit Rating among Peers.
  • Operating Since 1979 and Maintaining Excellent Reputation Since. An Industry Leader.
  • Rating:
    4.6 /5 on Feefo
    Editorial (Corporate): 99.4%
Currencies Direct Logo
  • Supported Currencies: 59.
  • Clients From: Globally , with the exception of certain U.S states. Offices in UK, EU, USA, Canada, China, South Africa and India.
  • Authorised? Yes, by the FCA.
  • Guidance / Dedicated Dealer: Yes.
  • Online System: Yes, including an app.
  • Strong Point: Superb Service, Experienced Dealers, Batch payments, Forward contracts, Multi-Currency Wallets and Rate Alerts.
  • One of the leading currency brokerages turning over £7.5bn annually.
  • Rating:
    4.8 / 5 on TrustPilot
    Editorial: 97.8%
  • Supported Currencies: 121.
  • Clients From: Only accepts corporate clients & does not accept U.S businesses.
  • Authorised? Yes, by the FCA.
  • Guidance / Dedicated Dealer: Yes.
  • Online System: Yes, including an app.
  • Strong Point: Exchange Rate Margins of 0.25%-0.15% for Large Turnovers.
  • Trading more than $7bn each year.
  • Rating:
    9.8 /10 on Feefo
    Editorial: 91.4%

For starters, our FX hedge comparison consisted of listing the best companies for buying foreign exchange derivatives and currency hedging tools. While some business foreign exchange specialists 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.

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

Hedging Strategies for Consideration

Natural Hedges

The most obvious approach is to take advantage of any “natural hedges” that occur within your business. For example, when you generate revenues in a foreign currency it can also be used to pay for costs incurred in the same currency. If the majority of your sales are in USD then you may look to seek financing in USD too. Natural offsets of this sort provide a measure of protection.

Similarly, if you have a heavy reliance on two currencies it may prove beneficial to keep an equal value of each currency. For example, if your company is exposed to GBP and USD, it can offset any GBP depreciation with gains by USD and vice versa.

Natural hedges used on their own do have their limitations and will not provide total protection against currency risk.

Rolling Hedges

Companies with ongoing exposure to exchange rate volatility may use forwards, swaps or options contracts to hedge against currency swings. A rolling hedge will help to mitigate risk by closing a soon-to-expire hedging product (such as a forward or option contract) and simultaneously opening a new contract, pushing back the maturity date of the initial hedging product.

CFO Brian Yoor of the US healthcare giant Abbot implemented a successful 18-month rolling hedge strategy. “ We went through to see where hedges were available in certaincountries and whether they were affordable… we were able to use a blend of certain instruments that generated income for us in a very volatile environment.” Depending on how rates have moved in your currency pair through the duration of your hedging contract it may prove more expensive to renew your existing hedges but Yoor continued “You’re still realizing a benefit, but it’s not as much year-on-year,”

Dynamic Hedging/Pricing

Dynamic hedging has traditionally been used as a hedging tool for overseas investment portfolios. Mitigating the risk of currency movements to ensure your assets remain a true reflection of their underlying value. Nowadays, technology companies are utilising a similar concept for businesses who sell internationally.

Businesses who sell goods or services overseas with prices in a foreign currency face continuous exposure to fluctuations in exchange rates of those currencies. There are three options the company has:

  1. Make no hedges. Simply use the exchange rate available on the day you are looking to repatriate your overseas earnings. Doing nothing is certainly not an active strategy, but taking the rough with the smooth day-by-day is still very much a currency strategy.