Foreign currency hedging involves the purchase of hedging instruments to offset the risk posed by specific foreign exchange positions. Hedging is accomplished by purchasing an offsetting currency exposure. For example, if a company has a liability to deliver 1 million euros in six months, it can hedge this risk by entering into a contract to purchase 1 million euros on the same date, so that it can buy and sell in the same currency on the same date. Here are several ways to engage in foreign currency hedging:
- Loan denominated in a foreign currency. When a company is at risk of recording a loss from the translation of assets and liabilities into its home currency, it can hedge the risk by obtaining a loan denominated in the functional currency in which the assets and liabilities are recorded. The effect of this hedge is to neutralize any loss on translation of the subsidiary’s net assets with a gain on translation of the loan, or vice versa.
- Forward contract. A forward contract is an agreement under which a business agrees to buy a certain amount of foreign currency on a specific future date, and at a predetermined exchange rate. By entering into a forward contract, a company can ensure that a definite future liability can be settled at a specific exchange rate.
- Futures contract. A futures contract is similar in concept to a forward contract, in that a business can enter into a contract to buy or sell currency at a specific price on a future date. The difference is that futures contracts are traded on an exchange, so these contracts are for standard amounts and durations.
- Currency option. An option gives its owner the right, but not the obligation, to buy or sell an asset at a certain price (known as the strike price), either on or before a specific date.
- Cylinder option. Two options can be combined to create a cylinder option. One option is priced above the current spot price of the target currency, while the other option is priced below the spot price. The gain from exercising one option is used to partially offset the cost of the other option, thereby reducing the overall cost of the hedge.
One should decide what proportion of risk exposure to hedge, such as 100% of the booked exposure or 50% of the forecasted exposure. This gradually declining benchmark hedge ratio for forecasted periods is justifiable on the assumption that the level of forecast accuracy declines over time, so at least hedge against the minimum amount of exposure that is likely to occur. A high-confidence currency forecast with little expected volatility should be matched with a higher benchmark hedge ratio, while a questionable forecast might justify a much lower ratio.