5-minute read
💡 If you haven't read our blog post on exposure types, you can find it here:
What is hedging?
In finance, hedging is the process of taking a position in an asset with the purpose of offsetting losses in another. For corporates managing their currency risk, the term 'hedging' is generally used as a catch-all phrase for the use of any FX trade to reduce or remove risk on an underlying currency exposure (as opposed to another financial asset).
We can define hedging as offsetting losses by taking an opposite position. If you had a liability in dollars then the offsetting hedge would be to buy dollars.
Harry Mills, Founder & CEO Oku Markets
Here's an example:
- You have a liability of $1.4million falling in six months' time
- You plan the cost in pounds at an exchange rate of $1.40, so £1million
- This means you are exposed to a fall in the value of the pound vs the dollar
We can see from the chart below that if the £/$ exchange rate falls, your underlying position suffers losses – the $1.4million costs more in sterling than you planned.
You could hedge this position, and potential loss, by purchasing a forward contract to buy $1.4million. This way, regardless of how the exchange rate moves, your cost to cover the dollar liability is fixed.
How much & how far?
The example above is pretty straightforward: buy $1.4million for delivery in six months. But most businesses also hedge their future forecasts in a process known as cash flow hedging.
Deciding the amount to hedge and over what timeframe depends on a few factors:
- Visibility of the size and timing of known and probable future transactions
- Certainty of forecasts, e.g. consider a contract with milestones vs historic trends
- Sensitivity to changes in the underlying exchange rate
It might be tempting to try to predict the market, but we recommend having a plan. There's nothing wrong with taking advantage of a favourable market entry price, but not having a plan – and purely relying on opportunism – might catch up with you.
Harry Mills, Founder & CEO Oku Markets
Static Hedging Programme
- A 'set and forget' approach
- Often an annual hedge against the FY budget
- Arguably inflexible in its simplicity
- More dynamic when using currency options
Rolling Hedging Programme
- Hedging a fixed amount to a future date
- Then periodically repeating and extending
- This ensures a constant hedge ratio over time
- Achieved rates are somewhat smoothed
Layered Hedging Programme
- Hedge ratios are greater for near dates, when visibility and certainty are higher
- Regular top-ups to maintain the hedge profile
- Achieved rates are smoothed over time
Held to account
An often-overlooked advantage of working to a programme is shared accountability. If responsibility for currency risk lies with one person, their market view, emotions, and decision-making could impact business performance. By agreeing an approach, the business removes the risk that one person makes a bad call on the market, and instead the risk is managed appropriately.
What next?
Understanding the sources of currency risk in your business is the first step. Quantifying the risk, and assessing it against your corporate objectives and risk tolerance comes next. Oku Markets can help with these stages and then model a hedging programme based on your specific circumstances and needs.
Write to us at [email protected] or call 0203 838 0250 to take the next step in managing your business' currency risk.
