Hedging currency risk is a useful tool for any savvy investor that does business internationally and wants to mitigate the risk associated with the Forex currency exchange rate fluctuations. In this currency hedging guide we’re going to outline a few standard and out of the box currency risk hedging strategies.
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Currency hedging is a great tool to preserve your profit margins and minimize your costs, without potentially leaving money on the table. Foreign currency hedging can help you do business internationally while mitigating these risks and at the same time maximizing your business opportunities.
Big companies don’t necessarily do currency hedging because they know where the market will go. Quite contrary, they hedge because they don’t know where the market will go!
Hedging currency risk simply gives a company the change to lock in the Forex exchange rate fluctuations and secure the profits if the hedge currency rates are less favorable.
Are you prepared to revamp the foreign exchange equation in your favor?
After this lesson, you’ll be able to understand the purpose of hedging currency risk and identify profitable currency risk hedging strategies.
Hedging Currency Risk
When it comes to doing business abroad as a US investor, investing overseas, you’ve got a big problem.
How are you managing your foreign exchange exposure?
When you do business abroad and buy or sell goods in a different country you’ll have to either pay for purchases in the foreign currency or earn income from sales in the foreign currency. You can lose market access if you don’t operate in the local currency.
So, pricing in local currency can open the door to do business internationally.
Let’s see now how investing overseas exposes you to investment and currency risk.
Currency Hedging Explained Through a Real Example
Currency hedging example:
Let’s imagine you have $10.000 to invest and you decide to invest the money abroad in the European market. The first thing you need to do so you can have access to the European market is to exchange your US dollar into euros.
The EUR/USD exchange rate is trading at 1.1154, which gives you 8,965 euros to invest in the European market.
Let’s assume you invest the money successfully and the investment rises by 5,000 euros. Now, you’ve got:
8,965 initial investment + 5,000 profit = 13,965 euros
You now want to cash in and bring back the money home. However, to accomplish this you have to exchange your euros back into US dollar.
We’re going to assume the EUR/USD exchange rate has remained unchanged at 1.1154. That’s a bit unrealistic because we’re ignoring transaction costs and other factors. However, this example will teach how the currency exchange rate can impact our investment strategy.
At the EUR/USD exchange rate of 1.1154, will net you $15,548, which is $5,548 in profits on your original investment of $10,000.
This is a positive scenario that rarely happens.
In some instances, you may sell your product when the hedge currency rate is favorable, but not get paid until later when the exchange may shift and is less favorable eating from your profit margins. In some instances, if the currency exchange rate movement is more severe you can incur even a loss instead, despite earning a profit from the sale of your goods.
Let’s now imagine the same scenario where you invest $10,000 but when you bring back the money into the US the EUR/USD exchange rate has moved. The euro has weakened considerably and suddenly the 13,965 euros you have at the new exchange rate of 0.7165 turns back into $10,000, which means that your overall US dollar profit is zero.
What happens here is that our investment abroad, which generated a profit of 5,000 euros was canceled out by the currency exchange rate.
The beauty of the currency exchange rate is that they can move in your favor to increase your profits. You can make a profit from your investment and some more once you bring back your money.
The problem is that we have a big range of outcome and lots of uncertainties that is down to foreign exchange movements. A lot of investors don’t want to live with that kind of uncertainty and take that foreign currency risk so they do currency hedging.
Hedging currency risk allows investors to protect against FX fluctuations that can annihilate their hard work. You can use currency hedging strategies if you’re not comfortable running foreign exchange risk.
Currency Risk Hedging Strategies
Luckily for us, there are some sensible practical things we can do relatively easily. Moving forward, we’re going to explore some of these ways to hedge currency rates.
If you’re someone who has assets abroad and wants to eliminate the FX risks you can simply hedge currency rates.
How this works is very simple.
Let’s go through a very common type of currency hedging scenario.
In this case, we assume that Boeing wants to sell its airplanes to a Japanese customer. In order for a US company to have access to the Japanese market, they need to sell their product in Japanese Yen. So, Boeing now accepts payments in Japanese Yen.
Boeing agrees to accept the payment after 90 days from the settling date. In this case, we have a transaction that settled on January 1st and a payment of 1.2 billion Japanese Yen will be made on March 31.
Now, what is Boeing, a US company doing business in US dollars going to do with 1.2 billion Japanese yen?
Like any company, Boeing wants to sell its planes for a profit and not speculating on the Forex exchange rates. In order to eliminate the currency exchange risk they can use a currency forward exchange contract.
Note: a forward contract gives the owner the obligation to buy or sell an asset at a specific price on a future date.
The 90-day forward rate for the JPY/USD exchange rate at the settled date of January 1st is at 0.0083. This means that Boeing will receive $10 million at the exchange rate of 0.0083 on March 31. So no matter in what direction the exchange rate goes they have locked-in the $10 million.
This is how hedging currency risk works and this is one way you can eliminate this risk. There are different Forex hedging techniques like hedging currency risk with options or using a currency forward contract.
The alternative scenario for Boeing is to do nothing and go with whatever the exchange rate is by March 31. Depending on how severe the exchange rate movement is, the amount they get can vary by several million dollars. No serious business will gamble and jeopardize their profits and that’s the reason why currency hedging is a great tool to eliminate these uncertainties.
Conclusion – Currency Hedging and Risk
In essence, hedging currency risk eliminates the exposure associated with the movement of foreign currencies. Many investors seek to reduce or even eliminate the currency exchange rate risk by adopting currency risk hedging strategies.
For the US investors, currency hedging becomes important when the greenback is rising in value since this can make it more expensive to exchange your foreign profits. This will result in eroding some of the profits and even possibly lose all the profits due to the extreme exchange rate fluctuations.
The bottom line is that the easiest solution to eliminate the FX exchange risk is to use currency risk hedging strategies through many avenues available such as forward contracts, futures, ETFs or options.
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