In today's globalized economy, companies engaging in international trade face various challenges, one of the most significant being foreign exchange risk. Changes in exchange rates can affect the value of revenues, expenses, assets, and liabilities denominated in foreign currencies. Multinational corporations are acutely aware of how FX markets can impact their profitability and utilize specific tools known as financial derivatives to mitigate currency risk. The strategy is referred to as hedging and is an integral part of any large company’s plan for international business.

Smaller companies doing business across borders face the same challenges, but they discover that managing FX risk on their own can be a daunting task. FX markets are complex and dynamic. Effective risk management typically requires high-level expertise that small-to-medium sized businesses don’t possess. Those who explore hedging often find that the associated expense and labor outweigh the benefits, so they wind up absorbing negative FX movement as a cost of doing business. Unfortunately, the losses due to adverse currency moves can be devastating to their bottom line. The potential for FX losses is a clear impediment to any company that envisions a global business strategy.

In this article, we’ll explore what currency hedging is, and the common FX hedging instruments used by global companies to mitigate foreign exchange risk.

A Currency Hedging Example

A US-based company sells avocado oil to the American market. Each month they import approximately $500,000 worth of avocados from Mexico. Over the last two years, the Mexican peso has increased by 20% against the dollar. The monthly outlay is now $600,000 for the same amount of avocados. Do they raise prices for their customers or accept a major hit to their profit margins? Neither option is desirable, so what can they do? If they had access to currency hedging they could have set up a FX hedging strategy that would have kept their avocado costs stable as the peso moved higher. 

The recent movement in the peso, though substantial, is not unusual. Major currencies often have moves in excess of 10% during the course of a normal year. Currency trends commonly continue for long periods of time as underlying macroeconomic conditions persist for years.

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Using our example above, let’s look at some financial instruments (called “derivatives” in the FX markets world) that this company in our example above could employ to solve this problem. 

Tools of the Trade: How Derivatives are Used for Currency Hedging

FX hedging utilizes financial instruments known as derivatives to manage the risk of currency fluctuations. Derivatives are contracts that allow the user to establish in advance the precise price they will pay for a currency transaction in the future.

Forward Contracts:

Forward contracts are among the most straightforward and commonly used derivatives for hedging foreign exchange risk. A forward contract is a contract between two parties to buy or sell an asset (foreign currency) at a specified future time at a price agreed upon today. The price of the forward is determined by calculating the interest rate differential between the two currencies over the time of the contract. Forward contracts can be customized to fit the size of the transaction and the date for fulfillment.

Using a forward contract, our importer could have locked in pricing in advance for the pesos he needed to purchase avocados, keeping his costs stable over time. He would have been able to focus on running his business without concerns about the impact of the rising peso.

Futures Contracts:

Similar to forward contracts, futures contracts provide a way for companies to hedge against currency risk by fixing exchange rates for future transactions. The key difference lies in the standardized nature of futures contracts, as they are traded on organized exchanges. Unlike forward contracts, futures contracts can be liquidated at any time if the hedging entity decides that there is a reason to exit the hedge. 

Futures contracts could have been used as an alternative to forwards to mitigate peso risk for the avocado importer. He could have gone long peso futures, producing a profit on the futures transaction that would have offset his higher cost for pesos.

Options Contracts:

Options contracts provide companies with the right, but not the obligation, to buy or sell a currency at a predetermined price within a specified timeframe. This flexibility makes options a versatile tool for hedging foreign exchange risk. Options are generally preferable for hedging major currencies that trade with substantial volume and liquidity. Options may be exchange-traded or purchased in an over-the-counter (private party) transaction.

In our example above, the avocado importer could have bought peso call options that would have increased in value with the rising peso. The importer would have known in advance that his total cost of hedging would be limited to the premium paid for the options.

Currency Swaps:

Currency swaps involve the exchange of cash flows in different currencies between two parties. These agreements help companies obtain more favorable financing terms in foreign markets while mitigating exchange rate risk. Swaps can be a very effective tool for FX risk management, but it can be challenging to find the right counterparty to take the other side of the transaction.  Most swaps are transacted using the services of a swap dealer who has the expertise to match the needs of the two parties entering into the agreement.

If the avocado importer needed peso-denominated financing for his purchases he could have considered a swap arrangement with a Mexican entity to lock in stable payments in dollar terms.

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