A foreign exchange hedge (also called a FOREX hedge) is a method used by companies to eliminate or “hedge” their foreign exchange risk resulting from transactions in foreign currencies (see foreign exchange derivative). This is done using either the cash flow hedge or the fair value method.
The accounting rules for this are addressed by both the International Financial Reporting Standards (IFRS) and by the US Generally Accepted Accounting Principles (US GAAP) as well as other national accounting standards.
A foreign exchange hedge transfers the foreign exchange risk from the trading or investing company to a business that carries the risk, such as a bank. There is cost to the company for setting up a hedge. By setting up a hedge, the company also forgoes any profit if the movement in the exchange rate would be favorable to it.
Hedging refers to different strategies that reduce the risks and minimize the impact of eventual adverse movements in the market. It involves using financial instruments to increase protection against unforeseen fluctuations, thus making cash flows more stable and predictable. As a result, companies can estimate income, taxes and revenues more reliably.
However, hedging is not a way of making more money. It is rather a series of methods for minimizing risks. Hedging reduces not only your potential loses, but it also reduces potential sudden earnings.
For investors, hedging is like buying insurance on their assets or portfolios. Foreign exchange hedging is common among investors and companies involved in international operations. It allows them to manage their exposure to currency exchange movements and minimize the impact of adverse fluctuations.
Some companies might choose to hedge 100% of the portfolio, while others might not hedge at all. Most of them, however, are likely to hedge a percentage, so they partially protect themselves but also accept some risks and leave the door open to additional earnings. It depends on their particular tolerance to risk.
Main methods for hedging foreign exchange risk
Different assets and types of investments have different methods for hedging, so there is no specific set of tools for hedging. In foreign exchange, however, hedging methods mostly consist of specific contracts or agreements meant to exchange currency at a fixed rate.
Let’s examine some of the most important and common options.
Forwards contracts or forwards are agreements between two parties to buy or a sell a specific amount of currency at a predefined exchange rate. If the foreign currency you’ll be exchanging into domestic currency loses value, you will still receive the exchange rate specified in the contract, so you won’t lose any money. However, if the foreign currency appreciates, you will still receive the same exchange rate, so there are no additional earning.
By selling futures, investors might hedge devaluations. By buying futures, they hedge appreciation. For example, a U.S. company will receive 25 million British pounds in three months, so the company sells futures for delivery in 90 days. If the pound depreciates against the dollar, the expected amount is protected. However, if the pound appreciates, the company won’t make any profit from the favorable exchange rate.
Debt operations involve borrowing foreign currency. An investor borrows currency in the amount they expect to receive in the future. Then they exchange it into local currency and deposit it, hedging exchange rate risks. When the investor receives foreign currency, they use it to pay the debt. However, local interest might not be enough to pay the loan’s interest, so this can sometimes be an expensive method.
Swaps are contracts between two parties that need foreign currency, but don’t want to borrow from a foreign bank. They exchange an initial amount and gradually swap back small amounts as interest. Finally, they return the initial amount. They usually borrow domestic currency as well, so the small amounts pay the loan’s interest. Swaps are common among financial institutions.