In business, the term "hedging" refers to a practice that may offer protection against the risk of potential losses of your finances.
The practice is similar to taking insurance to protect yourself from one or another loss, such as protecting your vehicle from accidents or theft. Find out more about the practice and strategies of hedging against currency risk below.
What is hedging in business?
The simple answer to the question, “What is hedging in business?” is that it is an insurance-like practice. If you decide to hedge, you are essentially trying to insure yourself against the impact of a negative event on your foreign currency or currencies. While hedging cannot prevent negative events from happening, proper hedging can reduce the impact of those events.
To pick up on the car insurance example mentioned above, insurance will not prevent accidents or theft from happening. However, if your vehicle is stolen, the insurance pay-out can lessen the impact of the theft on your finances, as you will not need to pay in full for a new car out-of-pocket.
Some strategies of hedging against currency risk may reduce your exposure to different types of risks. However, those strategies are not as simple as paying a monthly or annual insurance premium. When it comes to forex, the meaning of hedging in business refers to using market strategies or financial instruments in a strategic way to offset the risk of adverse price movements.
How does hedging work?
The meaning of hedging in business may become clearer when you see how it works with regard to foreign exchange. Take a British company that makes knitwear for example. Local sales see the company earn in pounds. However, if they sign a contract for bulk sales of knitwear to a US company, fluctuations in the GBP/USD exchange rate means the company is open to losses or gains before exchanging their dollars for pounds.
Without hedging, the company will have no idea what the exchange rate will be when it exchanges the dollars for pounds. The challenge then is to find the best way to protect the company from exchange rate-related risks. There are several strategies of hedging against currency risk, such as forward contracts, orders, and options. By choosing a forward contract, the company can fix the price in advance. Options can offer participation in exchange rate improvements while limiting worst-case scenarios.
Strategies of hedging against currency risk
Taking a closer look at strategies of hedging against currency risk offered by Moneycorp, you will find products such as forward contracts, FX orders, vanilla options, and zero-cost options.
- Forward Contract: With a forward contract, you can buy currency on an agreed date in the future at a pre-fixed rate. You can lock in a rate for up to two years. You may need to make a deposit when taking a forward contract.
- FX Orders: A FX order may help you secure a better deal if you need a particular exchange rate but do not need to purchase currency straight away.
- Vanilla Options: Vanilla options are the most basic of options. With one of these options, you have the right rather than the obligation to exchange currency at a particular rate on a specified future date.
- Zero-Cost Options: Zero-cost options do not require an up-front premium. They do not have all of the benefits of vanilla options although they can still offer protection against adverse exchange rate fluctuations.
Contact Moneycorp for more information about hedging and strategies of hedging against currency risk today.
Please be advised that our Options products may not be appropriate for all prospective clients.