International Money Transfer – Hedging Strategies
Risk, fear and panic are words that have a great impact on people, businesses and economies.
Most international market players get usually worried about market fluctuations and would seek to protect themselves against adverse market movements. Let’s imagine that you live in London, and plan to buy a property next year in the United States for $300,000. At the current GBPUSD exchange rate of 1.56, you know that the property would cost you £192,307. However, things can quickly change and the house could end up costing you way more. Should the rate go down to 1.46, the same house would cost you £205,479. In other words, you would lose £ 13,172 in the transaction. How volatile are currencies? View a currency summary for 2016.
So, in order to avoid these situations and enable you to mitigate risks, several financial instruments have been developed. While some of these instruments can be very simple and intuitive, others can require deeper finance related skills and knowledge.
We will go over most of the tools provided by money transfer and exchange houses and try to explain how they work. Again, while some companies such as MoneyCorp and Currency Solutions, provide a wide range of solutions, other limit themselves to the simplest tools. Throughout this article, we will walk you through the different financial products that will enable you to mitigate your risks or in other words hedge your fx exposure, similarly to the way they enable quicker, cheaper transfer by optimizing payment systems.
View our TL;DR Video Below
Forward Transactions – The Basic Hedging Tool
Provided by most exchange companies
This constitutes the simplest financial hedging instrument and it is provided by almost all money exchange houses. Basically, the contract is an agreement between you and a counterparty that consists in exchanging a certain amount of a given currency at a specified time in the future, and for a pre-determined rate. Basically, you could enter a 1 year forward contract where you buy $300,000 at 1.54. So by entering into this transaction, you would remove any type of uncertainty related to the cost of the house. In 1 year time, you would pay £194,805 and get $300,000 – which will be used for the acquisition of the house.
The agreed upon forward rate is usually linked to interest rate differentials between the currencies involved. Without getting into technical details, the forward curve can be whether 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 hedging horizon, while many houses enable to hedge the 1 year forward rate, others such as our recommended companies (lower on this page) offer more advanced options.
- Simple Instrument
- Liquid instrument especially on short maturities
- Total Hedge
- Positive Carry when the forward rate is better than the spot rate
- Negative Carry when the forward rate is less attractive
- Inability to capture a favorable market movement
Learn more about its pricing: Forward Contract Pricing.
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.
- You have the possibility to get the rate that you want
- No need for you to track things, it gets done automatically
- You are left unhedged when the target rate is not reached
- Your upside potential is limited as you can not fully capture favorable market movements
Stop Loss Order
This type of order can be extremely useful if you aim at hedging yourself against strongly negative market movements, while retaining upside possibilities. Lets say the current GBPUSD is at 1.56 and you want to be able to gain if the rate goes up. Basically, you could set a stop loss order at 1.54 (rate at which the transaction gets executed), which would constitute the worst case scenario.
- Negative market movements are hedged
- You retain an upside potential
- Less worries and more possibilities
- Can lock you in a yoyo market.
- Can slightly miss the worst case rate in case of sudden strong negative move
One Cancels Other Order
Basically, this is a combination of limit and stop loss orders. In our example you would set a stop loss at 1.54 and a limit order at 1.58. Whenever, any of these rates is reached, the transaction will get executed at that rate. Basically, this would enable you to hedge against wide market movements while keeping an upside potential (limited though).
As the graph suggests, this kind of order really protects against volatility and enables to hedge while keeping an upside potential.
- Limited Risk
- Upside Potential
- Limited Upside Potential
- Yoyo moves can drive both gains and losses
Less Common Tools For Hedging:
1. Time Option (Flexible Settlement)
A time option enable to settle the 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.
2. Option Structures
Basically, any kind of forward could be replicated by the use of options. Options are contract that can be whether bought or sold and that enable to achieve a particular financial objective.
3. Call Options
A call option is an agreement to buy an asset some time in the future and at a pre-determined 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 possibility. In the case above, the lower the strike rate, the higher the premium of the call option will be.
4. Put Options
Inversely, 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 wants 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.
5. Participating Forward
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 GBPUD 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 would be hedged below the strike rate (1.54), and you will be able to make gains above it.
- Downside Risk Hedged
- Upside Potential
- No Execution related worries
- 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 in order to mitigate particular exposures and/or capture possibilities.
Having gone through call and put options, let’s have a look at potentially useful structures using a combination of these instruments.
How will you know what is the best time to seek for 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 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.
At a time where market volatility makes a great impact on individuals’ and businesses’ budgets, it has become essential to plan carefully ahead. 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 hedge 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 to deal with the most technical companies when considering the use of these products. Given our performed assessments, along to customers’ feedback, you would get great guidance and advice by dealing through MoneyCorp and Currency Solutions when it comes to hedging risks.
Our recommended companies:
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