Currency hedging refers to a strategy that strives to minimize the exposure to exchange rate fluctuations, thereby minimizing the uncertainty of future transactions denominated in a foreign currency and providing some stability to earnings and cash flow. This is typically accomplished through the use of options or futures contracts.
Forward contracts can also be used to hedge currency risk. However, while forward contracts are superior to futures in terms of their overall risk reduction, there is no central market for forward contracts, which contributes to higher transaction costs and lower liquidity, as well as counterparty risk (i.e. the risk that the contract will not be honoured at expiration).
When a business chooses to hedge its exposure to foreign currency, the objective is to minimize uncertainty, not to maximize profit from currency speculation. A hedged position will therefore not produce the benefit of a favourable exchange rate movement, but at the same time will not expose the hedger to the loss potential of an unfavourable exchange rate movement.
The underlying principle of a hedging strategy is to construct a portfolio consisting of a long position in the foreign currency asset and a short position in a foreign currency asset such that gains on one offset losses on the other. This is achieved by using derivatives whose price movements are highly correlated with movements in the spot market.
Ideally, the derivative being used to hedge will have the same underlying currency as the foreign currency asset being hedged, since the price movements of the two assets would be highly similar.
Forward contracts give you a fixed cost for your foreign currency and therefore for your foreign currency purchasing. If the interest rates in the foreign country are higher than they are in the US, the forward rate is at a discount to the spot rate, and this reduces the dollar cost still more.
Forward contracts also have the advantage of being suitable for internal transactions. If your company exports to the country you are buying in, and wants to sell in local currency, purchasing in local currency reduces the company's currency exposure. The purchasing flow of funds offsets the sales office flow of funds. If an internal forward agreement is made between the two departments, only the difference between the two flows needs to be hedged at banks.
Options allow a buyer to take advantage of an increase in the value of the US dollar but protect against a decrease. Unfortunately, they are expensive. A six month option on a volatile currency typically costs about 5% and most people choose not to buy them. An added difficulty is that option prices for the European style options that buyers need are not well listed in financial newspapers.
Hedging does involve some risks, but they are limited and can be controlled with simple attention to the fundamentals. Risk arises from forecast inaccuracy, and can lead to unexpected price variations, either up or down. If a company over forecasts purchases and hedges with forwards, there will be larger profit or loss on the hedge than the variance on part cost.
With over forecasts, there will be a loss on forward contracts if the dollar strengthens and a gain if the dollar weakens. The total unexpected gain or loss will be approximately the percent over forecasted times the percent that the dollar changed. For example, a 20 % over forecast and a 15% currency strengthening will result in a 3% (15% of 20%) extra cost of the parts.
With under forecasts, some of the parts must be purchased at the spot rate without an offsetting hedge. If the dollar weakens, they will be more expensive and if it strengthens, they will be cheaper.
The biggest gains in currency management will come from choosing the right currency. A good negotiator should be able to get an initial price reduction of 5% or more against a volatile currency like the yen or the mark. The next most consequential decision is whether or not to hedge. Not hedging opens the buyer to dollar price swings that are often 20% in six months. This uncertainty is unacceptable to most companies.
The third decision is to choose a hedging strategy. A recent article in the International Journal of Purchasing and Materials Management showed the benefits of actively choosing a hedge strategy based on a Bayesian statistical analysis of probable outcomes. Over a five year period, actively choosing a hedge strategy would have saved 3.6 percent compared to paying in the supplier's currency (yen) without hedging, and 1.8 percent compared to always hedging with forwards. The authors did not consider options as a potential hedge strategy.
If buying in the supplier's currency without hedging is unacceptably risky, and buying in dollars is excessively expensive, the choice is between hedging with forwards and hedging with options.
If options were free, they would be the ideal choice, because they permit taking advantage of a stronger dollar and protect against a weaker dollar. However, options are not free, and almost always will be more expensive than forwards.
If you actively analyze probabilities of currency changes as the authors in the Journal recommend, and believe that the dollar will weaken, you should use forward contracts. They will give the same results as an option but at a lower cost. If you see no clear trend, make the choice based on relative costs. During two one-year periods when the dollar had no net change against the yen, options would have saved an average of 3.5% compared to forwards, before the costs of either.
If the difference in costs between an option and a forward contract is less than 3.5% and you predict no increase or decrease, consider buying an option.
If you predict a strengthening dollar, an option is the better choice. During a one year period of a strengthening dollar, options would have saved 7.71% compared to forward contracts.
