Proper Forex Hedging in Finance Leadership
A topic that typically receives a lot of attention (or avoidance) at executive eboard meetings is foreign exchange hedging(FX hedging or Forex hedging). This is because many consider it complex and “speculative.” As CFOs prepare for their next meeting, a critical challenge is to demystify the concepts and articulate the objectives of their approach to Forex hedging. Whether they’re hedging currency risk in an organized and elaborate manner already or not, the following post will outline the basics of FX hedging, how different parties in the corporate world benefit from currency swaps, and what finance leadership needs to know in order to safeguard their organization against risks in FX hedging.
Defining FX (Forex) Hedging
A forex hedge is a transaction implemented to safeguard an existing or anticipated position from an unwanted move in exchange rates. Forex hedges are utilized by a wide range of market participants, such as traders, investors, and businesses. Through the use of proper forex hedging, an individual who is long a foreign currency pair or expecting to be in the future via a transaction can be protected from adverse risk. On the flipside, an investor or trader who is short a foreign currency pair can protect against upside risk using a forex hedge.
It is critical to consider that a hedge is not a money making scheme. A forex hedge is intended to protect from losses, not to make a profit. Moreover, most hedges are intended to remove a portion of the exposure risk rather than the existence of the risk itself, as there are costs to hedging that exceed the benefits after a certain point.
For example, if a South Korean company is expecting to sell equipment in U.S. dollars, it may protect a portion of the transaction through taking out a currency option that will profit if the South Korean won increases in value against the dollar. If the transaction occurs unprotected and the dollar strengthens or maintains its value against the won, then the organization is only out the cost of the option. If the dollar decreases in value, the profit from the currency option can offset some of the losses realized when repatriating the funds taken from the sale.
Core Considerations Regarding Forex Hedging
Investors, traders, businesses and other market participants use forex hedges.
Forex hedges are meant to protect profits, not generate them.
Currency options are one of the most popular and cost-effective ways to hedge a transaction.
Forex Hedging Methods
The fundamental methods of hedging currency trades are spot contracts, foreign currency options and currency futures. Spot contracts are the typical trades executed by retail forex traders. Due to spot contracts having a very short-term delivery date (two days), they are usually not the most effective currency hedging vehicle. In fact, regular spot contracts are often why a hedge is needed.
Foreign currency options are among the most popular methods of currency hedging. As with options on other types of securities, foreign currency options give the purchaser the right, but not the obligation, to buy or sell the currency pair at a particular exchange rate at some time in the future. Regular options strategies can also be deployed, such as long strangles, long straddles, and bull or bear spreads, to limit the loss potential of a given trade.
Forex Hedge Example
IF a U.S. investment bank scheduled to repatriate some profits earned in Europe it could hedge a portion of the expected profits through an option. Because the scheduled transaction would be able to sell euros and buy U.S. dollars, the investment bank would buy a put option to sell euros. Through the purchase of the put option the organization would be locking in an 'at-worst' rate for the upcoming transaction, which would be the strike price. Similar to the example of the Korean company, if the currency is above the strike price at expiry then the company would not exercise the option and simply do the transaction in the open market. The cost of the hedge is the cost of the put option.
Not all retail forex brokers allow for hedging within their platforms. It is critical for finance leaders to research the broker you use before beginning to trade.
Results to Expect from Hedging
The core tenets of hedging is protecting and offsetting risk, and exchanging undesirable risk for desirable risk. Integrating a hedging program can help finance leaders fully understand and see the financials, giving them the confidence they need to improve the quality of their work.
But this reality only holds true when the CFO has reasonable expectations about what an FX hedge program can accomplish.
Too many CFOs falsely presume that currency is presented rationally in financial statements. This can lead to false assumptions about exposures and hedges. In reality, hedging programs can only deliver three results:
Results that reflect the instruments used
Results that reflect the functional currency structure
Results that reflect the objectives of the program
CFOs must have a significant impact on certain strategic decisions about functional currency, hedge program objectives, and derivative instruments to achieve their desired objectives.
Three Guidelines to FX Hedging
To maximize the results of their strategic decisions, finance leaders must adhere to three guidelines about FX hedging.
1. Own the Program’s Controls
FX hedge programs require procedures and controls to ensure they are properly executed and actually mitigate risk instead of creating it. Successful hedge programs have robust controls. Part of the role as CFO is to own these controls, which includes the following
1. Reporting: Reporting is the ultimate sum of your hard work. It proves that the hedge program is meeting the objectives defined in the policy within limits set by the policy. Proper reporting techniques and the utilization of agile FP&A technologies maximizes this aspect of Forex Hedging.
2. Accounting: Appropriate controls ensure that qualifying exposures are reflected in the financials at the hedged rate.
3. Trading: So far rogue FX traders haven’t been in the headlines in recent years, they nonetheless still exist. Solid trading controls separate traders from confirmations with counterparties and from accounting for their own trades.
As CFO, you steer the FX hedge program at a strategic level. Therefore, it is of paramount importance to set the key objectives for managing risk, understand what hedging FX risk can and can’t achieve, and ensure the company is tied to an appropriate control structure. That will give you the confidence as a finance chief to take the reins in leading efforts surrounding this critical facet of corporate finance.
2. Understand Your Program’s Limitations
Remember that your program’s results can only reflect the functional currency structure, objectives, and instruments used. These three aspects may limit your choices, even more so if they aren’t set cohesively. You may initially think of protecting the U.S. dollar value of your foreign revenue, and therefore you should hedge those foreign revenues.
However, consider this: Your functional currency structure, a decision likely made during the early stages of the company’s growth, will ultimately influence what you can and can’t hedge. It’s not do-able to hedge foreign revenues in a local currency functional subsidiary and receive favorable accounting treatment for derivatives. This is a classic limitation. On the other hand, there may be ways around this via proxy hedging strategies.
As CFO, your job is to establish and understand your organization’s philosophy and culture surrounding Forex risk management, which also means understanding the accounting structure and framework. For instance, you need to decide which derivative instruments the enterprise can use and why. The cheapest instruments lock in the USD value, impairing your ability to yield benefits from currency tailwinds to unhedged exposures.
3. Avoid Generic Objectives
FX risk management policies too often start with an objective along the lines of “to mitigate the impact of currency changes in the financials.” This is technically a true sentiment, but it lacks specificity.
Think more strategically about currency risk. As CFO you’re the decider in determining what matters most in the financial statements. Do you care about revenue? Operating income? If you could lock in the cost of sales for a year, would you? So, if that’s what you care about, why isn’t that your objective?
Clear cut objectives determine how an organization will define the success of the hedging program. Unfortunately, a generic unspecific statement could make any derivative the company uses look successful.
Finance leaders need to own the hedging program objectives. When the FX risk management policy and goals are set, ensure that it safeguards the areas of greatest significance. This may be predictability in cash or net income or insurance for your margin. The results you want to see will come, and you will be able to confidently explain them because the objectives are specific and originate directly from you and your priorities.