Understand what currency hedging is and how it works.

Currency hedging is a fundamental financial strategy in the international marketplace, providing protection for transactions, trade agreements, imports and exports. This tool is essential to mitigate risk in a globalized economy.

In this content, we will explore what currency hedging is, how it works, its main applications and its importance in risk management. Enjoy reading!

Understanding the Foreign Exchange Market

In international trade, companies face constant currency fluctuations. For example, when a Brazilian company sells a product to the United States, the selling price is converted into dollars.

The exchange rate, which defines how much one real is worth in dollars (or vice versa), is constantly changing. This movement is influenced by several factors, such as interest rates in each country, inflation, investor expectations and geopolitical events.

In practice, this exchange rate volatility creates a scenario of uncertainty and opportunity for companies engaged in international trade. For example, if the dollar appreciates against the real, Brazilian exporters can increase their sales to the United States because their products become more competitive.

However, when they convert dollars into reais, they receive less money than they originally expected. In addition, Brazilian companies that import products from the United States will have to pay more, reducing their profit margins.

Also read:

• Foreign exchange market: A journey to global investments

The role of currency hedging in the marketplace

Currency hedging is used by these companies to control the impact of price fluctuations on their business.

Currency hedging products are used to lock in a fixed exchange rate for a specific future date. That way, even if the purchasing power of the currency used in the transaction changes, the company can ensure the stability of its costs or revenues.

It is common to confuse hedging with speculation, but they are opposite concepts. Currency hedging is an essential risk management tool for international operations. By eliminating the uncertainty of future exchange rates, companies can focus on their core business, allowing for better planning and reducing the impact of currency fluctuations.

How are currency hedging strategies implemented?

Currency hedging can be applied in several ways, but there are four products that are most common in this market:

Forward contracts

This is a hedging instrument that uses a customized contract to buy or sell a commodity. Both parties agree on an exchange rate to be used at the time of payment. Typically, the forward contract is traded in dollars in the over-the-counter (OTC) market. The objective is to eliminate the uncertainty of exchange rate fluctuations and increase the predictability of amounts received.

Futures contracts

An agreement between a buyer and seller to determine the value of a foreign currency at a future date. Unlike forward contracts, futures contracts are traded on exchanges based on expectations of currency appreciation or depreciation. In these contracts, the exchange margins are adjusted based on exchange rate fluctuations.

Currency Options

Currency options differ from other financial products in that they allow the purchase or sale of a commodity at a predetermined exchange rate without any obligation to follow that rate. This provides greater flexibility to the buyer, who can choose the exchange rate in effect at the time of payment if it is more advantageous. However, to obtain this flexibility, the buyer must pay a premium to the seller.

Currency swaps

These are financial agreements in which two parties exchange cash flows denominated in different currencies. These market instruments are used to protect companies against exchange rate volatility and interest rate fluctuations.

See also:

• Futures Contracts: How They Work in the Grains and Oilseeds Market

Understand the stages of currency hedging

According to our expert, currency hedging requires 3 stages to be safely developed. By following these steps, a company exposed to exchange rates will find the necessary tools to protect itself from market volatility. See below:

Step 1: Identify the risk

According to Schuckar, the first step is to understand the market risks to which the company is exposed. This could be related to fluctuations in the dollar, the price of the Brazilian real, or fluctuations in the currency of the country in which you do business.

Market volatility is influenced by a number of factors. In Brazil, agriculture plays an important role. Extreme weather events, such as droughts or heavy rains, can affect agricultural production, which in turn affects the economy and the exchange rate.

In addition, the government’s economic policies, the central bank’s decisions and the international political scenario also contribute to market instability. By monitoring these factors, it is possible to predict trends that are part of the financial market.

Step 2: Measure risk

In a volatile economic environment, risk management becomes even more important. It is essential to understand the potential for financial loss in any business. By analyzing data, we can identify vulnerabilities and quantify the likelihood of adverse events.

This proactive analysis allows companies to prepare for unexpected challenges and make more strategic decisions that are aligned with their long-term goals.

Step 3: Managing Risk

Controlling financial risk requires a dynamic and adaptive approach. In-depth knowledge of hedging tools is essential to effective risk management because each business has unique characteristics and needs that require a customized strategy.

By mastering the various options available, it is possible to identify the ideal combination of tools to protect the company against the specific risks to which it is exposed. In this way, risk management becomes a more precise and efficient process.

It is in this pillar that Hedgepoint is an expert and can help the client understand this foreign exchange market.

Read also:

• Brazil’s Trade Balance: Understanding the Importance of Commodities

Apply currency hedging to your business

A  Hedgepoint has experienced professionals ready to meet your needs.

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