FX Hedging: Mitigating risks of exposure to foreign currencies

For treasurers operating in the foreign exchange market, the inherent challenges of FX trading are well-known. The FX market is the largest and most liquid in the world; trading currencies means dealing with  constantly changing prices. Every second, the buying or selling rate of a given currency changes; such volatility can hurt operators’ investments, resulting in significant losses for the company as a whole.

FX risk is an inevitable byproduct of this market, but one that can be mitigated by effective hedge strategies prior to trading. It is important to emphasize that hedging practices are not meant to generate profits but, rather, to protect the company and avoid substantial losses. It is a way to ensure that no money will be lost because of exchange fluctuations.

Proper tools that aid in the trade workflow are essential to devising efficient FX hedge strategies — or currency hedging — that effectively reduce or even eliminate the risk of foreign exchange exposure. When dealing with banks, companies have a lot more to lose with each closed deal, since banks always profit from spread rates.

If currency swings are a part of every trade, and treasurers need to continue trading as part of their workflow, how can they mitigate the impact of FX risk on their operations before they even occur?

Mitigating exchange-rate risk in the pre-trading stage

Hedging operations act as a price protection in which the participant protects, fully or in part, a given future exposure to foreign exchange against adverse variations in rates and prices. This strategy eliminates all uncertainty within an exchange rate, regardless of variations that may occur in the market. The practice of foreign currency hedging exists only when companies have international operations and exposure to foreign currencies, because hedging is not necessary for transactions carried out only in local currency.

For instance, it is common for export and import companies to have dollar futures contracts to protect themselves from abrupt fluctuations in currency rates. At that moment, the treasurer managing a portfolio seeks protection in case the currency does not have the expected rate or performance over a given period.  To carry out this type of analysis, treasurers should rely on a series of tools to provide all necessary information when designing their hedging strategy in the pre-trading stage.

Since hedging is optional for treasuries, questions raised by analysts regarding this strategy revolve around when and how to hedge and what possible benefits it might bring. Responses are not always the same, but are always obtained through full access to hedge instruments (NDF futures contracts, forwards, options, swaps, among others), interest curves, economic reports and news focused on market prospects. The assertiveness of your insights and information will determine the effectiveness of your hedging strategy.

The benefit and impact of foreign exchange hedging

The ideal hedge workflow includes predicting the likelihood of movement of a currency on a specific date to better plan your overall investment strategies. Then, comparing strategies and instruments to find the most appropriate structure for your exposures. How can you obtain all this information and then trade the chosen instruments?

With access to a solution that makes all hedge instrument prices available in a transparent way and allows for trading in the same tool, treasurers are able to perform such activity in a faster, optimized way. Without having to call multiple banks for quotes, the operator saves time and can visualize all prices in one place, making it easy for execution, getting the best price available and streamlining the process as a whole.

Moreover, when quoting with only a single bank, the treasurer is subject to the quotes and spreads of that specific institution, without knowing if the offered price is consistent with market average. If the company spends more in foreign exchange purchases (because of high spread),  cash flow could be negatively affected, thus limiting resources available for other activities. Should this occur, the company would have to go back to the bank and ask for a loan to cover such impact. This begins a vicious cycle, with the corporation always paying high spreads, damaging its cash flow and having to ask for credit from the same counterparty with which it traded the instruments.

Hedging is also an important step for treasurers to gain a realistic grasp of their company’s financial balance sheet as well as a clearer understanding of its overall performance. For corporations not performing such activity, exchange rate swings are not taken into account on the balance sheet, thus the presented profit may not reflect the results of product sales. For example, if a company in England has a balance of $1M USD at the beginning of the month, and, by the end of the month, the USD rises and the £ pound sterling depreciates, the balance sum in terms of the pound will be much smaller, but that would not mean the company sold less or is performing poorly compared with previous months. Understanding the financial health of the company’s balance sheet is essential to evaluate the company’s prospects as a whole, as well as being an important factor in presenting results to the Board and for making future decisions based on such reports.

Having access to a tool that allows hedge trading offers a significant advantage over the manual quoting process, but having a solution that also provides economic news and reports is an even bigger asset that brings even more benefits. Being able to access articles written by experts and researchers and set alerts to receive news in real time allows treasurers to gain a greater understanding of market perspectives, assets and instruments. Knowing firsthand that an event in the U.S. is moving the markets at a given moment and will have an impact on the price of the dollar, for example, can save time and warn treasurers of possible future variations in the exchange rate. Accordingly, they can prepare and integrate that knowledge into their hedging strategies.

Hedging practices applied to commodities

Depending on the company’s business line, its exposure is not limited to FX —  other asset classes may also receive a hedging strategy. Commodities are a very common example, since the prices of these products are also subject to massive fluctuations. If a company that manufactures plastic packaging, for example, only performs foreign currency hedging, it will not be protected in case of abrupt variations in the price of oil. As an example, the crisis in Venezuela in early 2019 had a major impact on oil production and exports, resulting in a significant change in the sale price. Such change would have had a much smaller impact on companies that had an oil hedge in place.

As commodity risk becomes more relevant to companies looking to reduce cash flow disruptions, automated solutions can optimize overall corporate P&L.

Strengthened by the use of hedging strategies and the right solution that aggregates all proper tools to perform such activities assertively, treasuries can better manage risk throughout the company. This reduces exposure to potential losses, improves cost-effectiveness, increases profitability and helps to identify new business opportunities more easily.

How the Bloomberg Terminal can help you:

• Get accurate quotes of futures instruments such as NDFs and swaps.
• Check prices with multiple counterparties at the same time.
• Check real-time results when trading with a particular counterparty in relation to others.
• Easily calculate the results produced by hedging.