Companies operating in the international marketplace are increasingly looking for strategies to minimise risk and increase predictability in the sector in which they operate.  One of the options available in the financial market is ‘currency hedging’, which provides protection against fluctuations and volatility in the foreign exchange market.

In this article, we’ll look at how currency hedging works in foreign trade and its importance in managing commodity risk. Enjoy the read!

What is currency hedging?

Currency hedging allows companies to fix an exchange rate at the time of negotiation to be used for a future payment. This provides predictability and security, especially for exporters and importers, by protecting their operations from exchange rate fluctuations. By establishing a fixed rate through a contract based on market analysis and historical averages, companies can avoid financial losses due to currency fluctuations.

Currency hedging in practice

Consider a Brazilian export company that enters a sales contract for $28,000 to be paid in three months. Currently, the dollar is quoted at R$5.00, which means that the company expects to receive R$140,000. However, without the protection of a currency hedge, there is a risk that the exchange rate will fall to R$4.80, reducing the revenue to R$134,400 and negatively affecting the profit margin.

To protect itself, the company enters into a hedging contract that fixes the exchange rate at R$5.00. Therefore, regardless of market fluctuations, it is guaranteed to receive R$140,000 at the time of payment. This allows the company to protect its margin, plan its cash flow with confidence, and mitigate the financial risks associated with exchange rate volatility.

Learn More About Currency Hedging Derivatives

Hedging works using derivative financial instruments, which allow the investor to take a position opposite to that of the asset. These include: SPOT, NDFs (Non-Deliverable Forwards), Vanilla Options, Exotic Options and Structured Products:

• SPOT – This is the most basic type of currency transaction. It involves the purchase or sale of a foreign currency for immediate settlement, where the exchange rate is fixed at the time of negotiation and payment is made in cash. This type of transaction is ideal for companies that need to pay for imports or receive payments for exports quickly and guarantees a fixed rate with no surprises due to exchange rate fluctuations.

• NDFs – These are non-deliverable forward contracts used primarily in markets where the currency is restricted or not freely tradable (such as some Asian and Latin American currencies). In these contracts, the parties agree on an exchange rate for a future date, but there is no physical exchange of the currency. Instead, the difference between the agreed rate and the market rate on the expiration date is settled in a widely traded currency, such as the U.S. dollar.

• Vanilla Options – These are traditional currency options that give the buyer the right, but not the obligation, to buy or sell a currency at a predetermined rate on a future date. These options are used by companies that want to hedge against currency fluctuations, but also want the flexibility to take advantage of favorable market changes.

• Exotic Options – These are customized structures that go beyond vanilla options and can include different terms, such as price barriers, multiple dates or variable rates. They are ideal for companies that have specific hedging needs and are willing to accept a higher level of complexity to achieve more customized protection or even lower costs.

• Structured Products – Structured products combine multiple financial instruments, such as currency derivatives, to create customized risk hedging solutions. They can include a mix of futures, traditional options and exotic options. These products are used to achieve a balance between protection and return potential.

The benefits of currency hedging

Investing in currency hedging offers several benefits:

1. Avoid financial losses: Protects against currency fluctuations by preventing future payments from being affected by increases in the value of the dollar.
2. Greater peace of mind: Provides exchange rate stability, eliminating worries about currency fluctuations.
3. Predictability: Facilitates the company’s financial planning, allowing for better organization and investment in projects.

Applying currency hedging to your business

Understanding which hedging instruments are most appropriate can be the key to avoiding surprises in your business. However, it is not enough to simply decide to use this form of protection: extensive study and prior knowledge are required to manage it effectively.

Relying on a specialist is essential for complete currency hedging protection. Hedgepoint has experienced professionals ready to meet your needs.

Contact us and manage the financial risks of currency hedging that can impact your company’s costs and results.

Disclaimer

This document has been prepared by Hedgepoint Global Markets LLC and its affiliates (“HPGM”) solely for informational and instructional purposes and is not intended to establish obligations or commitments to third parties, nor is it intended to promote an offer, or the solicitation of an offer, to buy or sell any securities, futures, options, currencies and swaps or investment products. Hedgepoint Commodities LLC (“HPC”), a wholly owned entity of HPGM, is an Introducing Broker and a registered member of the National Futures Association. Trading futures, options, currencies and swaps involves significant risk of loss and may not be suitable for all investors. Past performance is not necessarily indicative of future results. Hedgepoint clients should rely on their own independent judgment and that of external advisors before entering into any transaction that is introduced by the company. HPGM and its associates expressly disclaim any liability for any use of the information contained in this document that results directly or indirectly in damages of any kind. If you have any questions that are not resolved by our customer service team ([email protected]), please contact our internal ombudsman channel ([email protected]) or 0800-878 8408/[email protected] (for customers in Brazil only).