Why you need a hedging strategy to mitigate foreign exchange risk
How hedging strategies can act as an insurance policy against foreign exchange risk
Hedging means taking out another bet to cut the chance of your first choice letting you down. If your long odds horse comes in you still go home happy: if not you cover the cost of your investment and come out without loss.
A business operating internationally can be exposed to significant risk due to fluctuations in exchange rates. Until recently, there were only two ways to manage your foreign exchange risk: wait until you need to make a foreign exchange transaction or payment and take the prevailing (spot) rate or fix the exchange rate with a forward contract.
Spot contracts operate where currency settlement takes place within two business days. Once your funds have cleared, the broker transfers the pre-agreed currency amount to your requested bank account.
A forward contract agrees an exchange rate for buying or selling a fixed amount of currency for a date in the future. “All our forward contracts are “Flexible Forwards” where the contract may be drawn down earlier than the pre-agreed settlement date,” says Alex Sullivan, head of corporate business at World First, the UK’s fastest growing foreign exchange broker.
Forward contracts give protection against adverse exchange rate moves but give no benefit from any subsequent improvement in the rate, he explains.
However, there is another way. You can now hedge your business’s exposure, cut risk levels, and yourself from adverse rate movements while benefiting from favourable rate movements too.
“Gambling on foreign exchange is probably not your company’s core business. But in recent conditions, rates can move by more than your profit margin in a week and plunge you into loss. Doing nothing is not really an option, is it?” says Sullivan.
Hedging works a bit like an insurance policy by guaranteeing a worst case rate, he says. This will be inferior to the actual forward contract rate. The difference between these two effectively ‘pays’ for you to be able to benefit from a favourable move in the rate, which can be unlimited.
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A very attractive proposition at a time when the pound is low against the euro and the dollar but confidently expected to benefit when these and other major international currencies come under pressure later in the year.