Currency Hedging 

Currency hedging is one of the financial strategies employed by businesses and investors to reduce the risks caused by fluctuations in foreign exchange rates. Considering the increase in international trade, there is a need to upgrade management risk. This article attempts to get into the gritty of currency hedging: definitions, strategies, types, and real-life applications. 

What is Currency Hedging? 

Currency hedging involves financial instruments to mitigate the potential loss caused by an adverse movement in exchange rates. It reduces the volatility in cash flows and investment returns resulting from changes in foreign currencies. In effect, it is a form of insurance against currency risk that will stabilise the financial outcomes of entities operating internationally or investing abroad. 

A company trading internationally bears risk regarding currency. For instance, if a Singaporean exporter sells products in USD if the USD depreciates against the SGD, the selling revenue will be reduced when converted back into Singapore dollars. Businesses can lock in exchange rates or offset potential losses through currency hedging. 

Understanding Currency Hedging 

Currency hedging simply gives one an advantage in declining the risks associated with other exposures arising out of fluctuations in currency rates through the use of instruments such as forwards, options, and swaps.  

• Forward Contracts: These are agreements between two parties agreeing to convert amounts of currency after some time at a previously agreed rate. For example, if a company expects to receive its money in USD after three months, it can enter into a forward contract and sell USD at the present rate today to lock in its expected revenue. 

• Options: Options give the owner the right to purchase currency at a fixed rate before or on a given date. This will help the firm gain from favourable movements and hedge against unfavourable changes. 

• Swaps: Currency swaps refer to swapping principal and interest payments in one currency for those in another. Firms usually employ this style to assume control over long-term foreign currency exposure. 

Types of Currency Hedging 

There are various methods through which entities can hedge against their currency risks. 

• Cash flow hedge: This strategy attempts to hedge future cash flows from exchange rate fluctuations. It works best for companies with predictable revenue streams that are denominated in foreign currency. 

• Fair Value Hedge: This strategy minimises the risks of impacts arising from changes in the fair value of assets and liabilities due to changes in the exchange rate. It is often used for investments sensitive to currency fluctuations. 

• Natural Hedging: Some firms have used natural hedging, whereby revenue and costs match in the same foreign currency. For instance, if a firm earns revenue in EUR and incurs costs in the same EUR, its exposure to exchange rate risk is somewhat reduced. 

Hedging Strategies 

Effective currency hedging strategy requires careful observance of market conditions and business goals. For this purpose, some of the most common strategies are as follows: 

• 100 percent Hedging: In this strategy, an entity hedges the total exposure to foreign currency. This provides full protection against unfavourable movements while eliminating possible gains from favorable shifts in the exchange rate. 

• Partial Hedging: Another variant is partial hedging of a firm’s exposure. This strategy allows the firm to benefit from favourable movements while providing some protection against adverse changes. 

• Dynamic Hedging: In this strategy, firms upgrade their hedge positions in response to dynamic market conditions and projections. Dynamic hedging is complex to manage and track but can maximise coverage and returns. 

• Collar Strategies: Collar strategies involve buying a put option and selling a call option together. This limits the upper and lower potential losses within certain ranges and is cost-effective protection against extreme fluctuations. 

Examples of Currency Hedging  

A practical representation of how currency hedging plays out is presented as follows: 

1. Exporting Company: A Singapore company exports electronics worth USD1million. To hedge against the possibility of the USD depreciating up to three months before payment, the company locks into a forward contract at an exchange rate of 1.35 SGD/USD. They will receive 1.35 million in SGD regardless of what happens at the time of payment.

2. Investment Fund: The investment fund has massive assets denominated in EUR but reports its performance in SGD. The fund uses options to sell EUR at predefined rates while keeping the upside if the EURO appreciates.

3. Multinational Enterprise: A multinational enterprise will have business operations in Europe and Asia. It will use natural hedging, under which revenues and expenses will cancel each other significantly in their local currencies within every region. This would decrease its overall exposure and simplify cash flow management.

Frequently Asked Questions