4-minute read
Creating a currency hedging programme for a business requires thought and a detailed understanding of the unique position and needs of the organisation. There is no shortcut and no copy-paste solution!
Many businesses choose to hedge some of their forecasted cash flows and leave the balance to trade on the spot market later.
✅ This can be useful if cash flows are not committed or the timing is uncertain
❌ This is a bad idea if the objective is to speculate and seek (hope) for FX gains
In this article, I'll explain how a forward+spot strategy works and introduce an alternative.
How does it work and, is it worth it?
Let's say a UK importer has upcoming payables of EUR 1 million. A few months ago, they hedged 75% of this exposure with a forward contract at a rate of GBPEUR 1.15, leaving the other 25% to trade at the spot rate.
⬆️ If the pound rises to €1.20, their costs would fall by £9,057
⬇️ If the pound falls to €1.10, their costs would increase by £9,887
The chart below shows the difference in cost at various spot rates for the 75% hedge + 25% spot strategy compared to trading the full amount at €1.15.
This may or may not be a good solution. To assess this we'd need to understand:
- Hedging objectives
- Risk tolerance
- Certainty of the cash flow; amount and timing
- Sensitivity to changes in the spot rate
An Alternative?
It is possible to obtain a 100% hedge with less than 100% contractual obligation to exchange. Such a solution is achievable through the use of currency options but, we won't go into too much detail here as we are not authorised by the FCA to deal in such financial instruments.
Disclaimer: At the time of publication, Oku Markets is not authorised by the Financial Conduct Authority. We do not carry on nor purport to carry on any regulated activity including, but not limited to, advising on investments, arranging investments, dealing in investments, or making arrangements with a view to transactions in investments.
👉 If you'd like to read more about a solution which would provide this payoff, then check out this article from our friends at Alt 21.
The chart below shows the total cost of purchasing EUR 1 million using the 75%+25% forward/spot strategy and, the alternative instrument ('participating forward') at a rate of €1.1425 – a less favourable initial protection rate.
👉 Note that we're deliberately using round numbers for the sake of the illustration
We can see that:
- (A) – The forward contract gives a better initial protection rate (1.15 vs 1.1425)
- (B) – The forward strategy leave downside exposure (higher cost)
- (C) – In a rising market, the forward strategy outperforms (lower cost)
Cut Through the Noise
We're proud to work transparently with our clients, and we work hard to break the asymmetry of knowledge and information in the FX market.
If you would like to review your FX strategy, consider starting out with our free FX Audit – info here: https://okumarkets.com/audit/
You can contact us for a review of your currency processes and for our guidance and suggestions at [email protected] or 0203 838 0250.
Thanks for reading 👋
Frequently Asked Questions
- What are the two types of forward contracts?
The two main types of forward contracts are deliverable forwards and non-deliverable forwards (NDFs). Deliverable forwards involve the physical delivery of the underlying asset at a future date at an agreed-upon price, while NDFs are settled in cash and typically used for currencies that have restrictions on their convertibility. Oku Markets provides three sub-types of deliverable forwards:
- Fixed Forward: the currencies are exchanged on the maturity date only
- Window Forward: the currencies can be exchanged within a date window
- Open Forward: the currencies can be exchanged at any time before maturity
- Who are the participants in the forward FX market?
Participants in the forward market include businesses, financial institutions, investors, and speculators. They engage in forward contracts to hedge against currency risk, speculate on future exchange rate movements, or fulfil contractual obligations.
- What is meant by a currency forward contract?
A forward contract is a customised agreement between two parties to buy or sell one currency in exchange for another, at a specified rate, on a future date. It is used to hedge against the risk of adverse rate movements or to speculate on future price changes.
- How does a forward contract work?
A forward contract works by locking in a price today for the future delivery of one currency in exchange for another. Both parties agree to the terms of the contract, including the price, quantity, and delivery date. On the delivery date, the cash flows are exchanged at the predetermined rate, regardless of the current market price.
- What are the benefits of forward contracts?
The benefits of forward contracts include hedging against exchange rate fluctuations, ensuring price certainty for future transactions, and mitigating risk associated with currency exposure. Forward contracts also allow parties to customise terms to fit their specific needs.
- How do you use FX forward to hedge?
FX forwards are used to hedge currency risk by locking in a future exchange rate for a specified amount of currency. To hedge with FX forwards, a business or investor enters into a contract to buy or sell currency at a predetermined rate on a future date, thereby protecting against adverse exchange rate movements.
