FOREX HEDGING - A PRACTICAL GUIDE
This webpage is designed to provide forex hedging information to both commercial and retail forex traders and forex hedgers. We have provided an outline and guidelines for both commercial and retail forex investors but, as each investor's hedging needs are unique, we can not possibly cover every existing forex hedging scenario.
Please click on the links below for additional forex hedging information:
A forex hedge is placed when a trader enters the forex market with the specific intent of managing existing or anticipated physical market risk exposure from an adverse move in forex rates. In simplest terms, an investor or trader who is long a particular foreign currency can hedge to attempt to protect against downside risk exposure (a downward price move). An investor who is short a particular foreign currency can hedge to attempt to protect against upside risk exposure (an upward price move). Both speculators and forex hedgers can benefit by knowing how to properly utilize a forex hedge.
II. Who Hedges Forex Risk Exposure
Both speculators and forex hedgers can benefit by knowing how to properly utilize a forex hedge.
A. Banks. Banks who deal internationally have inherent risk exposure to foreign currencies, often in multiple ways including trading vehicles. Placing a currency hedge can help to manage forex rate risk.
B. Commercials. Both large and small commercials who conduct international business also have risk exposure to foreign currencies. Selling in foreign currencies and accepting forex rate risk are often a function of day-to-day business and can help commercials stay competitive.
C. Retail Investors. Retail forex traders use forex hedging to attempt to protect open positions against adverse moves in forex rates. Placing a currency hedge can help to manage forex rate risk.
III. Why Hedge Forex Risk Exposure
International commerce has rapidly increased as the internet has provided a new and more transparent marketplace for individuals and entities alike to conduct international business and trading activities. Significant changes in the international economic and political landscape have led to uncertainty regarding the direction of forex rates. This uncertainty leads to volatility and the need for an effective vehicle to hedge forex rate risk and/or interest rate changes while, at the same time, effectively ensuring a future financial position.
Each entity and/or individual that has exposure to forex rate risk will have specific forex hedging needs and this website can not possibly cover every existing forex hedging situation. Therefore, we will cover the more common reasons that a forex hedge is placed and show you how to hedge forex risk.
A. Forex Rate Risk Exposure. forex rate risk exposure is common to virtually all who conduct international business and/or trading. Buying and/or selling of goods or services denominated in foreign currencies can immediately expose you to forex rate risk. If a firm price is quoted ahead of time for a contract using a forex rate that is deemed appropriate at the time the quote is given, the forex rate quote may not necessarily be appropriate at the time of the actual agreement or performance of the contract. Placing a forex hedge can help to manage this forex rate risk.
B. Interest Rate Risk Exposure. Interest rate exposure refers to the interest rate differential between the two countries' currencies in a forex contract. The interest rate differential is also roughly equal to the "carry" cost paid to hedge a forward or futures contract. As a side note, arbitragers are investors that take advantage when interest rate differentials between the forex spot rate and either the forward or futures contract are either too high or too low. In simplest terms, an arbitrager may sell when the carry cost he or she can collect is at a premium to the actual carry cost of the contract sold. Conversely, an arbitrager may buy when the carry cost he or she may pay is less than the actual carry cost of the contract bought. Either way, the arbitrager is looking to profit from a small price discrepancy due to interest rate differentials.
C. Foreign Investment / Stock Exposure. Foreign investing is considered by many investors as a way to either diversify an investment portfolio or seek a larger return on investment(s) in an economy believed to be growing at a faster pace than investment(s) in the respective domestic economy. Investing in foreign stocks automatically exposes the investor to forex rate risk and speculative risk. For example, an investor buys a particular amount of foreign currency (in exchange for domestic currency) in order to purchase shares of a foreign stock. The investor is now automatically exposed to two separate risks. First, the stock price may go either up or down and the investor is exposed to the speculative stock price risk. Second, the investor is exposed to forex rate risk because the forex rate may either appreciate or depreciate from the time the investor first purchased the foreign stock and the time the investor decides to exit the position and repatriates the currency (exchanges the foreign currency back to domestic currency). Therefore, even if a speculative profit is achieved because the foreign stock price rose, the investor could actually net lose money if devaluation of the foreign currency occurred while the investor was holding the foreign stock (and the devaluation amount was greater than the speculative profit). Placing a forex hedge can help to manage this forex rate risk.
D. Hedging Speculative Positions. Forex traders utilize forex hedging to attempt to protect open positions against adverse moves in forex rates, and placing a forex hedge can help to manage forex rate risk. Speculative positions can be hedged via a number of forex hedging vehicles that can be used either alone or in combination to create entirely new forex hedging strategies.
IV. Types of Forex Hedging Vehicles
Below are some of the most common types of forex hedging vehicles used in today's markets as a forex hedge.
*Retail forex traders typically use forex options as a forex hedging vehicle. Banks and commercials are more likely to use forwards, options, swaps, swaptions and other more complex derivatives to meet their specific forex hedging needs.
A. Spot Contracts. A forex contract to buy or sell at the current forex rate, requiring settlement within two days.
As a forex hedging vehicle, due to the short-term settlement date, spot contracts are not appropriate for many forex hedging and trading strategies. Forex spot contracts are more commonly used in combination with other types of forex hedging vehicles when implementing a forex hedging strategy.
For retail investors, in particular, the spot contract and its associated risk are often the underlying reason that a forex hedge must be placed. The spot contract is more often a part of the reason to hedge forex risk exposure rather than the forex hedging solution.
B. Forex Options. A financial forex contract giving the buyer the right, but not the obligation, to purchase or sell a specific forex contract (the underlying) at a specific price (the strike price) on or before a specific date (the expiration date). The amount the forex option buyer pays to the forex option seller for the forex option contract rights is called the option "premium."
A forex option can be used as a forex hedge for an open position in the forex spot market. Forex options can also be used in combination with other forex spot and options contracts to create more complex forex hedging strategies. There are many different forex option strategies available to both commercial and retail investors.
C. Interest Rate Options. A financial interest rate contract giving the buyer the right, but not the obligation, to purchase or sell a specific interest rate contract (the underlying) at a specific price (the strike price) on or before a specific date (the expiration date). The amount the interest rate option buyer pays to the interest rate option seller for the forex option contract rights is called the option "premium." Hedging currency risk exposure with interest rate option contracts are more often used by interest rate speculators, commercials and banks rather than by retail forex traders as a forex hedging vehicle.
D. Interest Rate Swaps. A financial interest rate contracts whereby the buyer and seller swap interest rate exposure over the term of the contract. The most common swap contract is the fixed-to-float swap whereby the swap buyer receives a floating rate from the swap seller, and the swap seller receives a fixed rate from the swap buyer. Other types of swap include fixed-to-fixed and float-to-float. Interest rate swaps are more often utilized by commercials to re-allocate interest rate risk exposure.
E. Currency Forwards & Swaps. Currency forwards and swaps are more often used by institutions and commercials rather than by retail forex traders.
A forex forward is a contract to buy or sell a foreign currency at a fixed rate for delivery on a specified future date or period. Forex forward contracts are used as a forex hedge when an investor has an obligation to either make or take a foreign currency payment at some point in the future. If the date of the foreign currency payment and the last trading date of the forex forwards contract are matched up, the investor has in effect "locked in" the exchange rate payment amount. *Important: Please note that forwards contracts are different than futures contracts. Foreign currency futures contracts have standard contract sizes, time periods, settlement procedures and are traded on regulated exchanges throughout the world. Foreign currency forwards contracts may have different contract sizes, time periods and settlement procedures than futures contracts. Foreign currency forwards contracts are considered over-the-counter (OTC) due to the fact that there is no centralized trading location and transactions are conducted directly between parties via telephone and online trading platforms at thousands of locations worldwide.
A currency swap is a financial forex contract whereby the buyer and seller exchange equal initial principal amounts of two different currencies at the spot rate. The buyer and seller exchange fixed or floating rate interest payments in their respective swapped currencies over the term of the contract. At maturity, the principal amount is effectively re-swapped at a predetermined exchange rate so that the parties end up with their original currencies.
When hedging forex, virtually all forex hedging vehicles come at some cost. Carrying cost, option premium, margin, transaction and brokerage fees and hedging P/L are all costs that may be associated with hedging forex. However, if you look at the forex hedging cost from the proper perspective, you may very well find that the cost to place a forex hedge is relatively small compared to the potential benefits of placing the hedge. On the other hand, the whole point of placing a forex hedge is to offset forex market risk exposure at a reasonable cost - if a forex hedging strategy is not cost effective then the investor should explore other options for managing forex market risk.
The cost to place a forex hedge should be taken into account both before the forex hedge is placed, while the hedge is in place and again after the forex hedge is lifted. In theory, a forex hedging strategy will almost always look fairly good on paper before the forex hedge is placed. However, it is only after the forex hedge has been placed and then lifted that the actual effect is realized. There is a learning curve involved in forex hedging, and analysis and modification of the forex hedging strategy are part of the learning process.
VI. Forex Broker/FCM/FDM/Dealers
Forex risk management and hedging currency risk are extremely important aspects of banking, conducting international business, investing in foreign markets and retail trading of foreign currencies.
Banks and commercials will typically have specialized employees and/or professional advisors managing their forex risk management group.
*Retail forex traders: Most retail forex traders do not have a risk management group and must rely on a forex hedging broker or dealer for hedging advice and to broker forex hedging transactions. To remain objective, we will refrain from making any recommendations or criticisms about other brokers/dealers. The best advice we can give is this: simply identify the types of contracts you wish to trade, find an experienced forex broker who meets your trading needs, then make sure you are comfortable with both the forex broker and the brokerage firm that you will broker forex hedging transactions through. A good forex hedging broker will not only take the time to discuss your trading objectives but will also make sure you are aware of risk management and hedging tools that will help you attempt to protect your positions and make you a better trader.
As has been stated already, the forex hedging needs of banks, commercials and retail forex traders can differ greatly. Each has specific forex hedging needs in order to properly manage specific risks associated with forex rate risk and interest rate risk.
Regardless of the differences between their specific forex hedging needs, the following outline can be utilized by virtually all individuals and entities who have forex risk exposure. Before developing and implementing a forex hedging strategy, we strongly suggest individuals and entities first perform a forex risk management assessment to ensure that placing a forex hedge is, in fact, the appropriate risk management tool that should be utilized for hedging fx risk exposure. Once a forex risk management assessment has been performed and it has been determined that placing a forex hedge is the appropriate action to take, you can follow the guidelines below to help show you how to hedge forex risk and develop and implement a forex hedging strategy.
A. Risk Analysis. Once it has been determined that a forex hedge is the proper course of action to hedge forex risk exposure, one must first identify a few basic elements that are the basis for a forex hedging strategy.
1. Identify Type(s) of Risk Exposure. Again, the types of forex risk exposure will vary from entity to entity. The following items should be taken into consideration and analyzed for the purpose of risk exposure management: (a) both real and projected foreign currency cash flows, (b) both floating and fixed foreign interest rate receipts and payments, and (c) both real and projected hedging costs (that may already exist). The aforementioned items should be analyzed for the purpose of identifying forex risk exposure that may result from one or all of the following: (a) cash inflow and outflow gaps (different amounts of foreign currencies received and/or paid out over a certain period of time), (b) interest rate exposure, and (c) forex hedging and interest rate hedging cash flows.
2. Identify Risk Exposure Implications. Once the source(s) of forex risk exposure have been identified, the next step is to identify and quantify the possible impact that changes in the underlying forex market could have on your balance sheet. In simplest terms, identify "how much" you may be affected by your projected forex risk exposure.
3. Market Outlook. Now that the source of forex risk exposure and the possible implications have been identified, the individual or entity must next analyze the forex market and make a determination of the projected price direction over the near and/or long-term future. Technical and/or fundamental analysis of the forex markets are typically utilized to develop a market outlook for the future.
B. Determine Appropriate Risk Levels. Appropriate risk levels can vary greatly from one investor to another. Some investors are more aggressive than others and some prefer to take a more conservative stance.
1. Risk Tolerance Levels. Risk tolerance levels depend on the investor's attitudes toward risk. The forex risk tolerance level is often a combination of both the investor's attitude toward risk (aggressive or conservative) as well as the quantitative level (the actual amount) that is deemed acceptable by the investor.
2. How Much Risk Exposure to Hedge. Again, determining a hedging ratio is often determined by the investor's attitude towards risk. Each investor must decide how much forex risk exposure should be hedged and how much forex risk should be left exposed as an opportunity to profit. Forex hedging is not an exact science and each investor must take all risk considerations of his business or trading activity into account when quantifying how much forex risk exposure to hedge.
C. Determine Hedging Strategy. There are a number of forex hedging vehicles available to investors as explained in items IV. A - E above. Keep in mind that the forex hedging strategy should not only be used to attempt to protect against forex risk exposure, but should also be a cost effective solution help you manage your forex rate risk.
D. Risk Management Group Organization. Forex risk management can be managed by an in-house forex risk management group (if cost-effective), an in-house forex risk manager or an external forex risk management advisor. The management of forex risk exposure will vary from entity to entity based on the size of an entity's actual forex risk exposure and the amount budgeted for either a risk manager or a risk management group.
*Retail forex traders will most likely be self-reliant or will utilize the advice of a forex broker. Please see item VI. above for information on forex brokers.
E. Risk Management Group Oversight & Reporting. Proper oversight of the forex risk manager or the forex risk management group is essential to successful hedging. Managing the risk manager is actually an important part of an overall forex risk management strategy.
Prior to implementing a forex hedging strategy, the forex risk manager should provide management with forex hedging guidelines clearly defining the overall forex hedging strategy that will be implemented including, but not limited to: the forex hedging vehicle(s) to be utilized, the amount of forex rate risk exposure to be hedged, all risk tolerance and/or stop loss levels, who exactly decides and/or is authorized to change forex hedging strategy elements, and a strict policy regarding the oversight and reporting of the forex risk manager(s).
Each entity's reporting requirements will differ, but the types of reports that should be produced periodically will be fairly similar. These periodic reports should cover the following: whether or not the forex hedge placed is working, whether or not the forex hedging strategy should be modified, whether or not the projected market outlook is proving accurate, whether or not the projected market outlook should be changed, any changes expected in overall forex risk exposure, and mark-to-market reporting of all forex hedging vehicles including interest rate exposure.
Finally, reviews/meetings between the risk management group and company management should be set periodically (at least monthly) with the possibility of emergency meetings should there be any dramatic changes to any elements of the forex hedging strategy.
Forex hedging, when properly implemented, is a valuable forex risk management tool. However, when forex hedging is not properly implemented or supervised, the result can be catastrophic.
When implementing a forex hedging strategy, remember that trading and hedging forex is often an imperfect science. Understand that forex hedging has an inherent associated cost and that there is also a learning curve involved. If you are a retail forex trader who may need trading and/or hedging advice every now and then, make sure you have a broker who takes the time to understand your investment objectives and gives you non-biased advice.
Proper risk management is imperative is today's volatile forex markets, and we hope the free hedging information above has been a help to you.
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