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The basics of FX hedging strategies

The foreign exchange market is the world’s most active trading market. More than $5 trillion worth of currency pairs are traded every day as if it were a clockwork. This makes FX trading 25 times greater in volume than the global equities market. Yet while foreign exchange has grown to become a major strategic undertaking for many treasurers in corporate and the vast organizations they represent but it’s not without risks.

When companies are trading in multiple currencies, there is bound to be a high risk that their profitability and performance can be wildly affected as a direct result of fluctuations in exchange rates. due to the political uncertainty of global society as well as the updated rules of trading in Europe and the implementation of sophisticated new forex algorithms developed by innovative tech companies and huge incumbents and FX trading has been more prone to sudden and sudden declines in liquidity.

Flash crashes are occurring more often as well as bringing the specter of instability into foreign exchange that nobody wants to see. Overnight exchange fluctuations could dramatically raise a company’s costs of capital expenditure and diminish its market value, which is the reason why hedging against forex is absolutely vital to the success of all corporates trading across multiple currencies or dealing with supply chains with intricate processes that cross boundaries.

Hedging is a process by which companies buy or sell financial instruments in order to shield their positions from a negative change in one or more currency pairs. This usually means using various tools to offset or balance the current position in trading with a view to lower the overall risk for a company’s exposure. Yet it’s worth pointing out there are a variety of different hedging strategies treasury professionals can use to shield their companies from major fluctuations in currency – and each strategy comes hand-in-hand with their own set of pros and cons.

Start with the basics

There’s a misconception that FX trading is usually complicated or cumbersome. Some hedging strategies are a bit more complicated than other. However, many small-scale companies that do business internationally are able successfully manage fluctuations in currency by opening just one opposing position to any current trades.

The most popular and simple hedge technique is called”direct hedge”. This is when an organisation has a position that is already long on a particular currency pair, and then simultaneously, it takes the shorter position on the identical currency pair.

Why? Direct FX hedging strategies allow companies the ability to make trades in 2 different directions with the same currency pair, without having to close a trade and then record a loss to the books, or start fresh. In theory, this means that the firm’s position must remain stable regardless of any dramatic market changes that might happen along the way.

Direct hedging is not a way to make money, because it doesn’t always yield a net revenue. Yet it does provide relatively effective protection from currency shifts which in turn empowers corporates to make better operational choices with the knowledge there is constant protection from negative exchange rates.

It is important to note that not all FX service providers provide direct hedges – particularly those in the United States, where the National Futures Association has implemented a ban that prevents direct hedges in the majority of cases. Instead, brokers can suggest companies or treasury professionals to close the two or more positions in a currency for the same level of protection. However, for companies that are keen to earn a profit with the FX position or positions, it may be worth considering a multiple strategies for hedging currencies.

This take on foreign exchange has corporations pick two currency pairs that are positively linked and then take out oppositional positions on the pairs.

The most typical example is to take out the long-term position in an exchange like sterling, and US dollar, then also take a short position on the euro and the dollar. By selecting this strategy, an eroding euro will likely result in a loss on the sterling position held by a company, however, that loss could be offset by a substantial gain on a less expensive euro/dollar portfolio. A similar fall in the value of the US dollar would offset any losses associated with a short euro position.

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A multiple currencies strategy can be a fantastic way to shield yourself from currency fluctuations and (possibly) chalk up some profit, however it’s also a riskier take on FX. This is because, when hedging the risk of one currency, corporates will subsequently be open to at minimum two additional exposures to currency. If liquidity issues arise in multiple markets, or a long-lasting crash affects multiple currencies simultaneously using a multi-hedging strategy could be disastrous and result in losses on every cash position.

Take a look at all the options.

The use of currency options has increased in popularity over recent years as a strategic alternative to hedges, which can assist businesses in managing unstable markets for foreign exchange – just like hedging, there are a number of options available to the treasury professional when it comes to options.

First and foremost, there’s the ‘call option’ method. A call option is an insurance product that grants corporations the option of purchasing a foreign currency with a specified exchange rate until the date of a specific future date. On the flip side the other hand, businesses could choose the opposite ‘put option’, which gives clients the option to sell one currency pair at given rate.

It’s important to note there’s no way to tell if these currency options usually entails the obligation of the owner to make any exchange but they’ll be required to pay a substantial premium for the privilege of exchanging currency pairs at an agreed price.

These costs are generally high, which means that currency options aren’t always suitable for smaller-scale traders. However, they’re the preferred method for a lot of big corporates as they have the capability to significantly reduce exposure for a single, pre-paid cost. This reduces the chance of sudden transaction costs jumping out and surprising companies if currencies begin to change.

When considering FX options strategies, it’s also worth exploring the various single payment options trading (SPOT) products. This is a slightly more costly (and binary) alternative, since it comes hand-in-hand with extremely specific requirements that must be satisfied before the owner can get payment. A broker typically will add up the likelihood of those conditions actually being met with respect to a given currency pair or trade and then adjust the product price and commission accordingly.

Though a strategy to trade forex around SPOT options will generate more costs, it can make the life of customers. The reason is that most SPOT contracts are designed to generate a limited payout due to the fact that the exchange rate on the currency pair in question has matured (or has not matured) by or before the expiration date. This makes SPOT contracts an exceptionally low-maintenance way to protect against FX shifts. However, the downside is that payouts aren’t as big than what companies can expect to gain through a multiple strategies for hedging currencies.

Although hedging and options strategies are among the most popular ways in which companies work to protect their business from volatility in currency however, it is crucial to understand that they aren’t suitable for everyone. Corporates could instead opt to go into the futures market or use foreign accounts for currency to reduce FX risk or take out a forward exchange contract.

Simply put, there’s no right or wrong hedging approach when it comes down to forex. Each business will undoubtedly possess its own risk appetite, and treasury experts must work together with stakeholders to evaluate the risk appetite to create an FX strategy that’s right for a specific business.