Why do so many international businesses use currency hedging as a way to offset financial risk? There’s one reason, to exchange rates fluctuate every minute of every day. Your domestic currency might weaken between today and a purchase you plan to make early next year. Fortunately, there are all sorts of ways to minimize that risk. One of them is with forex options. Others include deals like forward contracts, naturals, and closed forwards. It’s important to understand that currency hedging can save companies huge amounts of money, is not as complicated as it sounds, and has been a common technique for many decades.
Currency Options
Companies of all sizes that do international transactions use currency options to protect their financial interests. How? They do it by hedging, which is another word for minimizing risk. If a person buys a cross-town bus ticket as a backup in case their car won’t start in the morning, they’re engaging in hedging. Corporations can easily use a Forex options trading platform to do much the same thing. Options contracts in forex work just as stock options do.
For example, XYZ Enterprises might want to buy Australian lumber next month but worries that the US dollar exchange rate against the Australian dollar will change to their detriment. In that case, XYZ could purchase a forex options contract that gives them the right to purchase Australian dollars at a specific rate. Note, XYZ is not obligated to buy the currency but can do so if they need to prevent losing money on a big fluctuation in exchange rates between now and the date of the lumber purchase.
Naturals
A natural is not actually a hedge, but it’s common for international companies to use the method. How does a natural work? Say your organization is based in the US but holds 10,000 euros in its bank account, left over from a previous transaction. Because you have several European customers, you leave the euros on deposit in the local bank for future use. Then, one of those clients contacts you offering a significant discount on, say, computer chips that you want to buy. The offer is to sell you chips worth 5000 euros one week from today. In this case, there’s no need for hedging because you already own more than enough euros to cover the purchase price, regardless of which direction the exchange rate goes.
Forwards
The term forward refers to the future and, in this case, means a seller and buyer agree on a fixed future exchange rate for the purpose of a specific sale. If Company ABC, based in the US, agrees to buy petroleum from a Russian seller but worries that the Russian economy is tanking, and the ruble is unstable. Because the seller will only accept rubles but badly wants to make the sale, they might agree to sell ABC the oil at a fixed ruble-to-dollar rate of 57-to-1. This arrangement is a forward contract that protects the US buyer by locking in the exchange rate. It protects the seller by guaranteeing the deal goes through. Most forward contracts set a sales date no more than 24 months in the future.
Closed Forwards
The closed forward is a transaction that comes with restrictions of several types. It’s basically an agreement made by a buyer to purchase a specified amount of foreign denominated money on a designated future day and date. All the particulars are spelled out in the contract. Here’s a hypothetical example in which your organization signs a contract stating that it will buy 1,000 euros for $1.03 each on April 10, 2023, at a total price of $1,030. Notice that with a CF, there’s no wiggle room. You can’t settle the deal earlier or later, or for any other price besides the one stipulated in the contract.
When Not to Hedge
It’s important for company owners and managers to realize that hedging is not a universal good. In other words, in an effort to brace yourself for rocky times, the technique doesn’t always make sense. Specifically, there are two circumstances in which hedging is probably a pointless endeavor. One, if you see no need for foreign currency in the near or long-term future, then it’s counterproductive to buy any non-domestic currency and hold it in an account. Most small businesses fall into this category because they don’t do any international transactions or can’t predict when they will ever. Second, if you intend to adjust the selling price of your goods to absorb any adverse exchange rates, then there’s no need to hedge. For organizations that routinely sell small quantities of goods overseas, time-of-sale price adjustments are simpler than entering into an FX hedge.
