Sculpting Foreign Exchange Risk – The Concept of Hedging

What is Foreign Exchange (FX) Hedging? By definition, it refers to the undertaking of financial contracts whose value changes in opposite direction to the value of the hedged item (FX exposure). Mouthful, isn’t it? Whilst statements like these may be correct, do they really explain how overall business risk is improved by using it? How does one even go about approaching it? As in all market classes, hedging in foreign exchange can be extremely challenging. Fortunately, there is a way to approach it which is both intuitive and manageable.

What is Foreign Exchange (FX) Hedging? By definition, it refers to the undertaking of financial contracts whose value changes in opposite direction to the value of the hedged item (FX exposure). Mouthful, isn’t it? Whilst statements like these may be correct, do they really explain how overall business risk is improved by using it? How does one even go about approaching it? As in all market classes, hedging in foreign exchange can be extremely challenging. Fortunately, there is a way to approach it which is both intuitive and manageable.

I invite you to think of foreign exchange risk as a big ball of clay. In it’s raw form, it is not attractive nor is it useful. Now, think of the different foreign exchange hedging contracts one could use as sculpting tools in your toolbox. Hedging refers to using these hedging contracts (sculpting tools) to mould the ball of clay into a shape that fits into the company’s overall risk profile. Whatever this shape may be, it doesn’t matter. With the right tools, and the right target shape in mind, the company could end up with a hedging strategy that provides acceptable currency conversion rates for all possible scenarios.

The best way to showcase the above is through an example:

Consider a company based in Canada (ABC Inc.) that is selling manufactured goods to the United States. They invoiced a customer for USD 1 million and will receive payment 3-months from now. In order to make the desired return, they are required to convert the USD to CAD at an exchange rate of 1.2700 or better (consider a current exchange rate of 1.2850). Any rate lower than this would result in ABC Inc. receiving less CAD than the minimum amount required for their return objective.

Without hedging, the client’s risk-reward scenario (ball of clay) looks as follows:

As you can see from the above, ABC Inc. basically gets the spot rate at the time of conversion. If the exchange rate moves to anything below 1.2700 in 3-months, they would not achieve their desired sales return. If the exchange rate moves to anything above 1.2700, they would earn much greater returns. Should ABC Inc. leave themselves exposed to the possibility of not achieving their target – so that they might end up with a more lucrative conversion rate? If they feel the risk is too high, they could search inside their “toolbox” for the right hedging contract that will shape their ball of clay. Say ABC Inc. decided to hedge 50% of their exposure using a Forward Contract (a contract that locks in the rate of conversion at maturity). The current exchange rate is 1.2850 and their forward contract rate is 1.2820. Their risk profile changes to being locked-in at 1.2820 for 50% of their USD and being exposed to spot for the other 50%. After doing the math, risk-reward scenario then becomes:

Notice that by using the Forward Contract Hedging Tool, we have reduced volatility on the possible exchange rate outcomes. ABC Inc would achieve a conversion rate of 1.2265 if the prevailing spot is 1.1700 and a conversion rate of 1.3265 (if the prevailing spot is 1.3700) – they are no longer completely exposed to spot. Suppose ABC Inc. still feels that there is too much exposure to USD weakness. They could choose to use Forward Contracts for 100% of the USD to be received, thereby locking in 1.2820 for the rate of conversion. This is definitely a shape to their foreign exchange risk that matches their needs, however it won’t allow them any participation in favorable exchange rate movements. They therefore decide to hedge 50% with a Forward and 50% with a different sculpting tool called a Deferred Put Option – paying the premium for the option only at expiry (more on this hedging instrument in a later article). Their risk-reward scenario then becomes:

Based on the above, the ABC Inc. would have a worst-case rate of 1.2705 (5 pips better than their budget rate of 1.2700) and they would be able to participate in favourable exchange rate movements – achieving a rate 1.3140 if the prevailing spot rate is 1.3700. ABC Inc. feels that the ball of clay they had in the beginning (pure spot exposure) has now been moulded into a shape that suits their overall business needs. They have protection at a rate of 1.2705, whilst allowing for participation in favourable movements. Foreign exchange hedging, when used correctly, can really be beneficial to a company’s long term financial goals.

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