Hedging is a term that is used quite often when it comes to matters related to investing. In the simplest of terms, it means taking measures against putting all your eggs in one basket. This is important because if in the event that basket falls and the eggs break, you will have a safety measure that will protect you from losing all your eggs at once.
Hedging can be seen as a form of insurance that an investor takes in order to protect his/her original investment.
This protection could be against any unforeseen circumstance that would otherwise cause the investor to lose all of their assets. Instead of losing everything, the investor is able to secure all or part of their initial investment. While it is a great idea, it does come at a cost to the investor.
Lots of people and companies argue that hedging is a waste of money because they could use this same money to gain higher returns on investment. But if you think about it, would you sleep well knowing that in the event of a catastrophe all your hard earned profits could disappear completely?
When a company in country A is doing business in country B, it will most likely have their accounts payables and receivables in country B’s currency. Often, country A will eventually need to convert their receivables from currency B to currency A and the vice versa also for their payables.
Considering the fact that the currency exchange rate between the two countries will fluctuate from time to time, country A may want to take advantage of an exchange rate that is most favorable to them. This is because when the volumes of payments are high, unfavorable exchange rates pose a huge risk to the company in country A. This risk is defined as currency risk.
Please keep in mind that hedging itself is not an investment tool, but a protection measure to ensure a company’s profits are not devalued due to market instability.
Forex hedging tools.
There are three major forex hedging tools that international businesses make use of to mitigate their currency risk.
Forward contracts – For example an Australian company has a contract to supply fertilizer to a Canadian company for 6 months. The Australian company is well aware of currency risk therefore it convinces the Canadian company to pay for the fertilizer at the end of the 6 months at the exchange rate which was there at the time of signing the contract. The Canadian company will therefore be bound by the contract to make the payout according to this terms regardless of whether the exchange rate will have changed after the 6 months.
Options – Forex options hedging involves entering into a contract that allows a company to buy (call) or sell (put) a certain currency at a pre-specified rate in the event that prevailing market rates are unfavorable. This comes at a cost to the company regardless of whether the company chooses to redeem the option or not.
Currency swaps – This where two companies exchange the same value of cash in different currencies for a period of time. They might do this for various reasons such as not wanting to increase their debt portfolio or even the need to fund a project using a specific currency. Over the period of the swap, both companies periodically swap back the small amounts of the principle currency as interest.
Risks of foreign exchange hedging.
While foreign currency hedging is meant to be a safety measure, it can sometimes have unintended results for the company that is hedging. For example, in a forward contract, a supplier may lock in certain exchange rate with a client. During the supply period, the exchange rate fluctuates in the supplier’s favor. Because the exchange rate was already locked in this ends up making the supplier lose out on profits that would have been realized by the favorable rate.
For a company that gets this concept wrong, they might be locked into paying premium price for a product that everyone else is paying peanuts for. Case in point consider an airline locking in a future to pay for jet fuel for one year. At the time of this agreement crude oil is selling at $100 per barrel, then the price of oil falls to $60 per barrel after 2 months and stays there. This means that for the next 10 months, the airline will pay almost double what its competitors are paying. This would be detrimental to their performance in that financial year.
So before hedging, it is very important to have a strategy that will protect your company’s investment rather than lose it.