How to use currency derivatives to hedge your currency risk

Over the past six months, we have seen strong volatility in global currency markets. Emerging market currencies weakened aggressively against the US dollar, which has strengthened significantly leading up to the Federal Reserve’s US benchmark interest rate hike last December. The volatility and thus currency risk in foreign exchange markets is not only an issue for governments and investors, but also for companies involved in international business.

Currency risk affects international companies

If you are a business operating outside your country’s borders, you will inevitably have to deal with currency risk. Currency risk, also known as foreign exchange risk, refers to the risk of a potential loss resulting from exposure to fluctuations in exchange rates. For example, if you are a US-based company and have revenue-generating activities in the UK, you will generate revenue in British pounds that will need to be translated back into dollars. For example, if your Q1 revenue from your company’s UK operations was £10 million, but the pound depreciated 5% against the dollar in Q1, then your actual income will be worth 5% less, as soon as you exchange it back into dollars at the end of Q1. This is why it is so important to implement an adequate currency hedging strategy, using financial derivatives, when you have operations abroad. That said, it is not always easy to use the full range of possible hedging tools. Retail clients and SMEs, for example, have limited access to these options through banks. In contrast, they have the option of using commercial FX services instead. Banks, on the other hand, tend to provide forex hedging solutions only to large multinational corporations. An online trading CFD brokerage firm can provide access to all major world markets with forex trading solutions that best suit your needs, whether you run a freelance business, SME or a large corporation.

FX Forwards

There are several possible financial derivatives used in the foreign exchange market that can help corporates, SMEs and retail clients hedge their currency exposure. The most common derivatives in this space are so-called FX forwards. An FX forward contract is an agreement between two parties to buy or sell an amount of a foreign currency at a specific price for settlement at a predetermined future date. By using FX forwards, you can ‘lock in’ the exchange rate at which you will exchange your money on the date you need to transfer it to another currency. This fully hedges you against currency fluctuations. However, it does not allow you to benefit from a favorable movement in the foreign currency in which you generate revenue. This is the only drawback of using forex futures as your choice of currency hedging tool.

FX options

An alternative to FX futures would be to use FX options to hedge your currency exposure. By purchasing an FX option, you have the right but not the obligation to exchange a sum of money denominated in one currency into another currency at a predetermined exchange rate on a specific date. The advantage of using FX options compared to FX futures is that if the foreign currency appreciates, you can still take full advantage of this move (minus the premium for the FX option), as you are under no obligation to exercise the option. So if you know that if the foreign currency reaches a certain level, your foreign company will lose revenue, you can buy a currency option with a strike at that level. You can exercise the option once that level has been reached to hedge your currency exposure in that currency.

Participating forwards

A third way in which you could hedge your currency risk is by using so-called participating futures. Participating futures provide a guaranteed exchange rate for your currency exposure, while still allowing you to benefit from favorable exchange rate movements on a predetermined portion of your currency exposure. For example, if you need to exchange GBP 1 million in three months into US dollars, you can enter into a participating forward contract that allows you to exchange the full amount at GBP 1.40 and agree a 50% participation rate. However, should the currency strengthen, say to 1.50, the participation futures will allow you to exchange GBP 500,000 at 1.40 and the remaining GBP 500,000 at the prevailing spot rate of 1.50. This is a great way to hedge currency risk exposure as you do not have to pay a premium for this derivative transaction.

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