What is currency hedging? Definition and meaning
Currency hedging applies to international equities and transactions and is designed to reduce the impact of currency fluctuations on the value of investments and international sales – it is a technique to guard against foreign exchange movements.
Currency hedging is like an insurance policy that reduces the impact of foreign exchange risk. It is used by businesses and investors that have international holdings or sell internationally.
In very simple terms, it is the act of entering into a financial contract so that you are protected against unexpected, expected or anticipated changes in currency exchange rates.
In the foreign exchange hedging process, you start off by identifying your exposures, and end by evaluating your results and adjusting accordingly.
Financial investors and businesses use currency hedging to eliminate the risks they encounter when conducting business abroad.
Many options in currency hedging
The currency hedger buys or books different types of contracts that are designed to achieve specific goals, which are based on the level of risk he or she is exposed to. The individual can lock in future rates without undermining his or her liquidity significantly.
“Hedging can be a very complicated enterprise. The various hedging mechanisms range from basic to extremely intricate.”
“The most prudent first steps, when considering a hedging strategy, would be to take note of potential foreign exchange exposure and, based on that, evaluate what goals need to be set and what actions need to be taken in order to mitigate that risk.”
Just like a hedge protects your garden from the wind and your property from trespassers, to hedge in business means to protect yourself from undesirable consequences.
Nasdaq’s Glossary of Terms says the following about a currency hedge:
“Applies mainly to international equities. Hedging technique to guard against foreign exchange fluctuations (i.e., short Euro 100 mm when holding a long position of Euro 100 mm in stocks).”
Hedging currency risk
Hedging strategies can help business people better control the daily currency fluctuations and enhance planning reliability of their companies.
Several options are combined to cover each person’s individual needs. In the majority of cases, the aim is to optimize the hedging price or hedging costs. Based on the individual’s risk profile or risk appetite, a number of strategies are possible (Data source: Credit Suisse):
– Base Hedging: this is ideal for people wanting full planning reliability with customized exchange rate hedging solutions and no lever. Base Hedging is suitable for people who are not interested in currency risks outside their core business.
– Advanced Hedging: this is ideal for people who want customized exchange rate hedging solutions and an additional level to minimize their currency risk. The investor wants to profit from favorable market developments and is willing to take some risk – in the worst case scenario he or she would not have full hedging.
– Outperformance Strategies: for people who want a much better acquisition price than the average forward rate. They are willing – in the worst case scenario – not to have full hedging.
Currency fluctuations expose investors and businesses to an additional variable when they choose to do business abroad – currency fluctuations. Currency hedging protects you from that variable.
Why is currency hedging important?
It is surprising how many investors do not realize it, but when they invest in international stocks, currency fluctuations have a significant impact on their returns.
Imagine you are an American who invests $1,000 in a London stock, and that locally in the UK that stock rises by 10%. You would think your investment had increased to $1,100, wouldn’t you – a rise of 10%.
But that is not the case – it may have increased by more or less than 10%. The value of your investment in US dollars will depend on the dollar-to-pound exchange rate. In London, where your investment is, equities are traded in pounds sterling.
Imagine US aircraft maker Boeing sells an airplane to UK based British Airways for £100 million, which at the moment means $130 million. However, after ninety days, when the invoice must be paid, the pound-dollar exchange rate may have changed. In order to fix how many dollars it will get, Boeing should arrange for a Currency Forward Exchange Rate Contract.
If, when you first purchased your investment the exchange rate stood at $1.50 per £1.00, and today the exchange rate is identical, then yes, it would have increased by 10%. But if the pound slid by 10% to $1.35, your increase would have been completely wiped out. Currency hedging protects you from these fluctuations.
Video – Currency Hedging
This Passing Score video explains the basics of currency hedging, giving the example of a US aircraft maker selling an airplane to Japan in Japanese currency.