Cash & Liquidity ManagementFXVolatile foreign exchange and hedging strategies

Volatile foreign exchange and hedging strategies

The global FX market offers huge potential for those with an appetite for risk – but as exchange rates become more volatile, treasury professionals must develop strategies to manage that risk. Nash Riggins explores the sector’s most popular hedging and options strategies and how they can be utilised.

The foreign exchange market is by far the globe’s busiest trading space. More than $5 trillion worth currencies are swapped every single day like clockwork – making FX trading activity 25 times larger by volume than the global equities market. Yet while foreign exchange has grown to become a core strategic activity for many corporate treasurers and the sprawling organisations they represent, it isn’t without its own serious perils.

Whenever corporates are trading in multiple currencies, there will inevitably be an acute risk their profitability and performance will shift wildly as a direct result of unstable exchange rates – and thanks to global socio-political uncertainty, updated trading rules in Europe and the deployment of complex new forex algorithms by enterprising fintechs and colossal incumbents, FX trading has become more vulnerable to very sharp and very sudden drops in liquidity.

These so-called ‘flash crashes’ are happening more frequently, and they’ve added a fresh injection of volatility into foreign exchange that nobody wants to see. Overnight exchange fluctuations have the power to drastically increase a company’s cost of capital expenditure and decrease its market value, which is why forex hedging is absolutely vital to the success of all corporates trading in multiple currencies or working with complex supply chains that transcend borders.

Hedging is a process by which corporates buy or sell financial products in order to protect their positions from adverse movements in one or more currency pairs. This typically means utilising multiple tools to offset or balance a current trading position with a view to lower a company’s overall risk of exposure. Yet it’s worth pointing out there are quite a few different hedging strategies treasury professionals can deploy to protect their respective organisations from big currency shifts – and each strategy comes hand-in-hand with its own set of pros and cons.

Start with the basics

There’s a huge misconception FX trading is often complex or cumbersome, and some hedging strategies are a bit more intricate than others. But many small companies doing business abroad are able to adequately mitigate currency fluctuations by simply opening a single opposing position to any current trades.

The most common simple hedging strategy is called a ‘direct hedge’. This is when an organisation already possesses a long position on a particular currency pair, and then simultaneously takes out a shorter position on the same currency pair.

Why? A direct hedging strategy enables companies to trade in two different directions on the same currency pair without having to close a trade, record a loss on the books and start from scratch. In theory, this means the company’s position should remain stable regardless of any sharp market fluctuations that could occur along the way.

Direct hedging is no way to make money, because it rarely generates a net profit. Yet it does provide relatively effective protection from currency shifts – in turn empowering corporates to make bolder operational decisions with the knowledge there is a constant degree of insulation from bad exchange rates.

It’s worth pointing out that not all FX services providers offer direct hedges – particularly in the United States, where the National Futures Association has implemented a ban that prevents direct hedges in a lot of instances. Instead, brokers may advise firms or treasury professionals to net off two or more currency positions in order to provide the same effective coverage. But for those organisations keen on gaining a profit using their FX positions, it could even be worth considering a multiple currencies hedging strategy instead.

This take on foreign exchange sees corporates choose two positively linked currency pairs and then take out opposing positions on those pairs.

The most common example would be to take out a long position on a pair such as sterling and the US dollar, and then simultaneously go for a short position on the euro and the dollar. By selecting this strategy, a weakening euro would likely generate a loss on a company’s sterling position – but that loss should be mitigated by a tidy profit on a shorter euro/dollar position. Similarly, a fall in the US dollar would offset any losses on a short euro position.

A multiple currencies strategy is a great way to insulate against currency fluctuations and (possibly) chalk up a profit, but it’s also a riskier take on FX. That’s because when hedging an exposure on one currency, corporates will subsequently be opening themselves up to at least two additional currency exposures. If liquidity becomes an issue across multiple markets or a sustained crash affects several currencies at once, a multiple hedging strategy could totally backfire and result in losses on every single cash position.

Weigh all options

Currency options have increased dramatically in popularity over recent years as a strategic alternative to hedging that can help corporates to navigate volatile FX markets – and just like hedging, there are a number of different routes available to treasury professionals when it comes to options.

First and foremost, there’s a ‘call option’ strategy. A call option is an insurance product that gives corporates the right to buy a foreign currency at an agreed exchange rate up to a certain future date. On the flip side, companies may wish to go with the inverse ‘put option’, which gives clients the option to sell a currency pair at a given rate.

It’s worth noting that neither of these currency options typically come with an obligation on behalf of the holder to make any exchange, but they’ll be expected to pay a tidy premium for the right to exchange currency pairs at an agreed price.

These premiums are typically quite expensive, and so currency options aren’t always suitable for small traders. That being said, they’re the method of choice for a lot of big corporates because currency options have the power to drastically reduce exposure for a one-off, pre-paid cost. This eliminates the risk of unforeseen transaction expenses jumping out and surprising companies if currency rates start to waver.

When considering FX options strategies, it’s also worth exploring any number of single payment options trading (SPOT) products. This is a slightly more expensive (and binary) option, as it comes hand-in-hand with extremely finite conditions that must be met before the holder can receive a pay-out. A broker will typically tally up the likelihood of those conditions actually being met on a given currency pair or trade, and then adjust the product premium and their own commission accordingly.

Although building a forex strategy around SPOT options will generate higher costs, it also tends to make life a bit easier for clients. That’s because most SPOT contracts are designed to automatically yield limited pay-outs simply because the exchange rate on a given currency pair has matured (or has not matured) by or before the product’s expiration date. That makes SPOT contracts an exceptionally low-maintenance way to protect against FX shifts. The catch here is that these pay-outs typically won’t be as high as a company could expect to gain through a multiple currencies hedging strategy.

While hedging and options strategies are two of the most popular ways in which companies work to protect themselves from volatile currency fluctuations, it’s crucial to note these strategies aren’t right for everyone. Corporates could instead opt to enter the futures market, rely on foreign currency bank accounts to manage FX risk or take out a forward exchange contract.

Simply put, there’s no right or wrong hedging strategy when it comes to forex. Each company will inevitably have its own unique risk appetite, and treasury professionals have got to work with stakeholders to appropriately gauge that appetite in order to develop an FX strategy that works for a particular business.

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