Forex Hedging Products Summary

Hedging enables you to manage risk and reduce potential risk. If you don't hedge, it's tantamount to speculating that the foreign currency rate will always stay the same, a costly assumption if the rate ends up moving unfavorably. A good hedging strategy can help eliminate currency exposure and the attendant risk associated with currency movement.

There are a number of products for hedging forex risk, which involve buying foreign currency now at known exchange rates (so you know what your costs are and have a sound basis on which to set the price of your product/service), or gaining the right to buy or sell foreign currency at a later date but at a fixed exchange rate.

Hedging products include:

Currency Forward Contracts
Futures Contract
Currency Options
Carry Spot Trade
Exotics and Other Alternatives

See a graphical comparison of Forex Hedging Products.

A cautionary note: beware of a bank's claim to “share in the upside” through the use of options or other exotic forex products. There is no such thing as a free lunch. These products offer a guaranteed forex rate in the future, as well as the privilege of receiving some or all of the benefits of positive foreign exchange rate movements. However, this privilege comes at a cost: you pay a much higher spread for the guaranteed rate or, in the case of options, an upfront cash premium.

Currency Forward Contract

When dealing with major banks, you can ask for a currency forward contract, which is a negotiated agreement between two parties to exchange specific amounts of currency at a set rate on a particular day. The forward rate is priced based on the current exchange rate, the interest differential for the contract time, a cost to cover potential negative changes to the interest risk differential, and a flexible built-in commission for the forward contract provider.

Advantages

The forward rate for purchasing or selling a foreign currency amount is locked in at a future date. The future exchange rate is known.
Future changes to interest rates, whether positive or negative, will not impact the forward rate. (Forward rates factor in the forward points or interest carry costs, typically with some sort of additional cost to cover potential changes to future interest rates for the traded currencies.)

Disadvantages

Often, the forward rate includes an uncompetitive exchange rate or built-in commission, making this solution costly;
You would require many forward contracts for more complicated scenarios (such as monthly payments);
Since a forward contract is between two parties, there is no secondary market for the purchase and sale of these contracts, making them rather inflexible or expensive to terminate early or extend; and

Futures Contract

Futures are similar to forward transactions in that the cost is based on the current exchange rate, the interest differential for the contract time, an amount to cover potential negative changes to the interest risk differential, and a formal commission.

Advantages

The major advantage of futures contracts over forward contracts is the existence of a liquid secondary market so they can be sold at any time on the open market and do not have to be held until their maturity date. Futures contracts can be traded on organized exchanges, such as the Chicago Mercantile Exchange (CME) or London International Financial Futures Exchange (LIFFE). These exchanges dictate contract specifications, such as expiration times (third Wednesday of March, June, September and December), face amount, and margin requirements.

Disadvantages (from a hedging perspective)

Futures contracts involve not just a spread, but also a commission;
The face value of futures contracts traded on exchanges are fixed. For example, British pound futures are sold in lots of GBP 62,500 and euros are generally sold in lots of EUR 125,000, making it difficult to hedge an exact amount;
A margin deposit must be posted and maintained daily;
There are limited expiration times;
Futures contracts are typically speculative, so taking delivery of the money at the end of the term is not expected and may cost a commission.

Currency Options

You buy currency options at a bank. A currency option gives the holder the right, but not the obligation, to sell or buy a face amount of currency at a set price, on or before a given date. A currency option has a strike price—the amount for which the currency can be bought or sold—and an expiration date. U.S. options can be exercised at any time up to and including the expiration date, whereas European options can only be exercised on the expiration date.

There are two types of options:

Call options give the holder the right to buy a given amount of a currency at the strike price.
Put options give the holder the right to sell a given amount of currency at the strike price.

Options are one-sided contracts that are priced based on a number of variables: exchange rates, interest differentials, duration of contract, historical exchange rate volatility, and a built-in commission for the provider. They offer a method of speculating on future currency movements, but you pay a price for that right to speculate.

Advantages

Like futures, the major advantage of options over forward contracts is the existence of a liquid secondary market, which means that they can be sold at any time on the open market and do not have to be held until their expiration date. Further, currency options are useful when hedging future foreign currency transactions that are uncertain, because you are not obliged to ever convert or exercise them. But this will come at a cost. If the foreign currency moves in a favorable direction, you will share in the gain (less the cost of the option). If the foreign currency moves in a negative direction, you may exercise your option at the strike price (guaranteed rate). However, you will still have to pay the option cost.

Disadvantages

Options traded on formal exchanges must be purchased in fixed face values and lot sizes. While some banks offer their own options in any notional amount, they may increase the option costs.
Options have to be purchased—there is a cost involved and premiums to pay.
You will bear the risk and potential cost associated with the difference between the amount to hedge and the fixed option amounts.
Options have expiry dates.

Carry Spot Trades

Currency hedging through online spot trading is surprisingly straightforward, given the new generation of currency trading platforms. All transactions can be completed over the Internet using a standard Web browser, at any time, 365 days a year for some suppliers and 5-24 for other suppliers. No bank visits are required (until it comes time to arrange your actual monetary transaction).

Advantages (from a hedging perspective)

You can purchase the exact amount you need to hedge;
Your forex hedge has no expiry date;
You can change the hedge amount at any time (either add to the forex hedge at current rates or reduce the forex hedge amount);
You can terminate part or all of the hedge at any time;
Based on the online forex broker, you will receive great low spreads; and
The interest differential (carry cost) is charged separately, which makes forex hedge accounting easier to administer.

Disadvantages

Retail forex hedging requires a margin account to cover any potential losses on your forex hedges. Regulations stipulate that a margin account is required as opposed to offering credit to customers.

Exotics and Other Alternatives

Exotic Forex Hedging Products

Exotics tend to be combinations of a variety of products (typically options and forward contracts) with many different names and flavours (including features such as floors, ceilings, collars, participating forwards). They are often sold with the promise of limited downside risk and the potential of unlimited or limited upside benefit. They’re similar to standard options, but should be left to very experienced forex traders because their complex structures often hide extra profits for their providers.

Foreign Currency Bank Accounts or Bank Loans

Of course your company could purchase the foreign currency today and deposit the foreign currency in a bank account. While the exchange rate would be fixed, your company would need to use significant amounts of working capital to implement this solution. Further, you would need to establish foreign currency bank accounts and may not receive competitive interest rates on these accounts. Alternatively, if you have a foreign currency asset to be realized, your alternative would be to take out a foreign currency loan. Once again, this may be difficult and costly to arrange as a mechanism to fix the foreign currency exchange rates.