What is foreign currency hedging?

Stop changes in foreign exchange affecting the profitability of your business.

What's foreign currency hedging, and why will it be valuable to my business?

Foreign currency hedging is the protection of your business against fluctuations in the prices of foreign exchange. You may be familiar with headlines such as "Australian Dollar drops to 0.68 US Cents" - with hedging, these headlines will no longer cause your business short-term concern.

This article is a primer for newcomers to the world of foreign exchange hedging, and illustrates the central concepts that businesses will have to understand in order to protect their cashflow. It covers:

  1. What are foreign exchange prices?
  2. What does foreign exchange hedging do?
  3. What are the downsides to hedging?

What are foreign exchange prices?

If you conduct business internationally, you have encountered the price of foreign exchange. In purchasing or selling goods overseas, you will have to convert from your domestic currency to the currency of the buyer or seller. For example, the current rate for Euros may be worth 1.15 American dollars. If you are an American importer, buying goods from Europe to re-sell, your expected cost today for 100 Euros worth of goods is 115 American dollars. But what happens when the price of Euros in American Dollars changes?

What does foreign exchange hedging do?

Let's understand hedging by example. Our American importer has seen an opportunity for profit, and has placed an order with a European manufacturer for goods worth 100,000 euros, expecting that these will cost him 115,000 American Dollars. The contract is accepted by the manufacturer, and payment is required when the goods are ready - in 90 days time. Our American importer now has two options: to hedge, or not to hedge.

If our American importer does not hedge, as the majority of small-medium businesses do not, they are unwittingly taking a gamble over the next 90 days. Three things may now occur, between now and when payment is due: the price of Euros in American Dollars may fall(1), stay stable(2), or rise(3). What is the result?

  1. Falling euros, no hedging: This is good for the importer. They are able to take a larger profit from the deal, as it will cost them less than 115,000 USD when payment is due.
  2. Stable euros, no hedging: This is neutral for the importer. They pay the 115,000 USD in 90 days, as expected.
  3. Rising euros, no hedging: This is bad for the importer. The goods are now going to cost the importer more than 115,000 USD. How much more is uncertain - depending on the rise, it could be a little, or a lot.

Now, what happens if our American importer does hedge his foreign exchange rates, at the time the deal is signed? Under the same 3 scenarios:

  1. Falling euros, with hedging: This is good for the importer. They are able to take a larger profit from the deal, as it will cost them less than 115,000 USD when payment is due.
  2. Stable euros, no hedging: This is neutral for the importer. They pay the 115,000 USD in 90 days, as expected.
  3. Rising euros, no hedging: This is now also neutral for the importer. The goods still cost more than 115,000 USD, but the hedge provider will pay out the difference in cost.

What are the downsides to hedging?

Hedging does cost a small amount upfront - the current cost for your currencies is always live on the front page of HedgeCheap.com. In return for the upfront fee, we can see that currency hedging protects us from being impacted by the bad scenario - it protects our deal from an increase in the cost of overseas currency. With hedging, our importer is no longer concerned about any immediate change in the cost of foreign currency - they are protected by the hedge.

For most businesses, certainty of ongoing cashflow is more important than riding the ups and downs of the foreign exchange market. Please give us a call today to discuss your hedging needs.

Disclaimer: This article is meant to be general guidance only, and should not be taken as financial advice. Seek specific guidance from a qualified professional for your particular situation.

Dimitri Vasdekis

Founder - HedgeCheap
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