Photo: Pixabay, Lyrics by Led Zeppelin
By Michael O’Neill
Gardeners use hedges to form a barrier, mark a boundary, or act as a wind-break. Corporations, institutions, and small businesses use hedges to perform a similar function, except these hedges are not botanical and do not need watering.
Financial hedges are used to mitigate risk in bond, commodity, equity, insurance, and foreign exchange. This article will focus on FX.
There are many types of foreign exchange hedges, but their primary use is for mitigating risk. Sounds sophisticated right? Not really.
Simply put, most times an FX hedge is the act of selling or buying a currency today, to cover an exposure at a later date. It’s not biomolecular science, although unscrupulous FX salespeople have been known to wrap a basic strategy in a convoluted shroud of complex-sounding jargon to inflate the markup on a trade.
So, why would a corporation or small business hedge?
Hedging risk sounds like a no-brainer and it is. What corporation wouldn’t want to reduce their FX risk?
The problem is that in many companies, FX is a miniscule part of the CFO, Treasurer, Controller, or accounting departments day as these people have a myriad of other tasks, and responsibilities. Many lack FX market experience, and are intimidated by a fast-talking FX salesperson, spouting jargon and statistics in the guise of in-depth, high level insight.
They shouldn’t be.
Often, the simplest, most common strategies are the most effective, and the most common technique is FX forwards.
An FX forward is a binding obligation between a client and a bank (or non-bank payment provider) that obligates the parties to exchange a pair of currencies on a specified date at a predetermined price. Even better, no money exchanges hands until the delivery date.
A forward contract is often utilized when a company knows it will receive a payment in a foreign currency on a future date and wants to lock in the price today.
For example, the fictious Widget Company, a Canadian based firm, will receive US $500,000 on September 8, 2021, a payment for some services. Widget wants the certainty of knowing its cash flow and avoid potential adverse currency moves.
Widget calls ABC Bank and agrees to sell US $500,000 today for delivery on September 8. ABC Bank agrees to buy US $500,000 at 1.2500 for value September 8. No money changes hands.
On September 8, USDCAD is trading at 1.2200. Neither party cares, as the spot rate does not have any bearing on the forward contract. Widget pays ABC Bank $500,000, and ABC Bank pays Widget CAD $625,000.
In this example, if Widget waited until September 8 to convert their US dollars, they would have received CAD $610,000, $15,000 less than the forward contract.
Conversely, if USDCAD was 1.2800 on September 8, Widget would still only receive CAD$625,000.
The above is an example of a “one-off” hedge.
Another risk management strategy is to use continuous FX forward contracts to partially hedge consistent, monthly FX receipts. The company determines the amount of FX volatility risk they will absorb and for what duration. Then they decide how much of their monthly foreign cash flow they would like to hedge and for what delivery date. Let’s assume 50%
Beginning August 5, they would like 50% of their monthly US dollar receipts hedged on the 15th of the current month, and for the following two months so that they are always 50% hedged for three months.
Every time a contract expires, it is replaced by another contract so that the next three months are hedged.
Similar hedging strategies can be incorporated using derivatives which provide far more flexibility.
One of the most important selling features for using FX forwards is that the principal payments only change hands-on delivery, not when booked.
However, there are costs associated with forwards. The bank or non-bank financial payment firm that buys or sells the forward inherits settlement risk. Large price movements could result in the FX forward being well below (or above) the prevailing spot level which is a marked to market loss for the client. Banks want to ensure that they do not suffer a loss if the contract is not delivered. To do so, they may demand an upfront “margin” payment which could be as high as 10% for a G-10 currency, and then insist that the margin balance cannot dip below a predetermined level.
If so, the customer may run into cash flow problems if they keep topping up margin to avoid having their forward contract unwound at current FX market rates.
USDCAD fell 0.0875 points between January and June, then rallied nearly 0.0750 since June. That equates to 0.1625 points of travel time, which is rather volatile. It is not over. Israel is threatening air strikes on Iran nuclear facilities, COVID-19 variants are rearing their ugly heads and even infecting vaccinated people. Inflation is rising, and central banks are beginning to talk about withdrawing stimulus. Hedging foreign exchange risk is a valid consideration.
Gardeners like hedges to provide barriers, and shrewd corporates like hedges to mitigate risk.