Ever wondered exactly what goes on when you organise a currency hedge? Laura Parsons from Tor FX explains
In this age when clients not only invest across the international environment but also live, buy and work across it, it isn’t too surprising that currency hedging has risen to such prominence. Tens of thousands of individuals and businesses, as well as the larger financial institutions and investment companies now regard it as an essential cornerstone of their financial strategies.
That’s not so surprising when you consider that the currency market is a highly volatile trading platform that can be shaken about by a myriad of political, social, environmental and economic developments.
The Corporate Case
Businesses in particular use the process to counterbalance the risks associated with international commercial transactions. The most obvious scenario being where a company decides to locate a proportion of its operations in a country other than its main export market so that it can hedge against currency risk. By taking a proactive approach to safeguarding an investment from probable, unpredictable and surprising fluctuations in foreign exchange rates, it’s possible to enhance profitability and reduce downside risks to a company’s growth prospects.
How’s it done? Well, the process can vary from being very basic to being highly complex, but it usually involves entering into one of several types of financial contracts – with clients having a view to achieve a particular outcome by locking in future rates without compromising their liquidity.
The outcome the corporate client wishes to achieve varies depending on the level of risk it is seeking to counter – and one of the first things an IFA should do when compiling a hedging strategy is to identify the potential foreign exchange exposures the client is facing.
· Do they import/export goods?
· Do they have foreign property holdings?
· Do they have to transfer employee wages?
Once these exposures have been identified, the next step is to devise a currency risk management policy for dealing with them and minimising the financial threat they pose.
Following this, budget rates and goals need to be determined before a hedging strategy can be formulated and executed. After the strategy has been deployed it’s imperative to analyse the results and readjust the terms if the approach isn’t successful.
· Key Things To Remember
· While the process of currency hedging can be fairly simple in itself, finding a comprehensible definition to offer clients new to the practice can be less so.
· In the most basic of terms, currency hedging is a form of insurance policy, a means of limiting the adverse impact of exposure to foreign exchange risk.
· When hedging against an investment risk, financial instruments known as derivatives are used to offset the hazards attached to negative price movements – with one investment being made to protect another.
· It’s important to bear in mind that reducing the risk attached to an investment means settling for a reduction in potential profits. This is not a means of making money so much as reducing potential losses.
· Prevention is better than cure, and protection can be more lucrative in the long term than appreciation. By developing a currency hedging strategy, it’s possible to reduce the risk of losing out when the value of the currency being held by an individual declines relative to other currencies.
· If the value of the currency you are hedging against increases, the profit you could have made is usually reduced. However, if the currency you are hedging against falls in value your hedge will prevent or diminish the loss you would have incurred.
Advising The Private Client
So how do these strategies translate to an IFA’s personal investor clients? How can they work within a portfolio context?
The first thing to say is that when working on a currency hedging strategy, an IFA is likely to find that working with a reputable currency broker secures the best results for a client – because these people have specialist knowledge of the derivatives typically utilised in currency hedging, including futures and options.
· A Forward Contract is an example of a futures contract, a straightforward currency hedging tool and something a currency broker can help your client structure. Effectively, a forward contract lets you secure a favourable exchange rate and buy/sell a currency at that fixed rate at a future time. The contract’s settlement date can usually be anytime within a twelve month period of the contract being drawn up.
· Because forward contracts provide your client with a predetermined rate of exchange, he or she can budget for future transactions and safeguard their investment from negative movements in the currency market. Of course, since your client is obligated to settle the contract at the fixed rate, they aren’t able to benefit if the exchange rate moves in their favour in the meantime. So they’re effectively trading a larger potential profit for security and certainty.
· Foreign currency options also offer a greater degree of control and assurance when buying/selling foreign currency. Buying foreign currency options gives the purchaser the ability to buy a foreign currency contract at a certain price (known as the strike price) on a certain date (known as the expiration date). If the contract’s expiration day comes around and currency fluctuations have made it profitable, the purchaser is entitled to exercise the option at the strike price. However, if the currency market has worked against them and made the option worthless the company doesn’t exercise it and it expires.
· Other avenues worth considering include Limit Orders (where a currency is purchased automatically once it hits a pre-agreed rate) and Stop Orders (where a currency is bought as soon as it drops to a pre-set minimum level).
Currency brokers will also monitor market movements and currency trends and are well positioned to offer your client specialist advice about the best time to make a trade and the best form of contract to deploy. You could so all these things for yourself, of course, but do you have the time and the experience?
Of course, one of the easiest means of currency hedging is simply to buy another currency. When your native currency is the pound (for example) and you buy US dollars, if the value of the pound should fall against the US currency, then you’ve sheltered your funds and you can buy back your pounds at a modest profit. Now, we should stress that currency brokers don’t engage in speculative trading of this sort. But it’s something that clients may wish to explore further. As long as the risks are very clearly explained, of course.
In short, currency hedging is all about reducing/transferring risk – and it’s a strategy which when successfully deployed can safeguard your client’s investments. Generally speaking, hedged portfolios produce more even results than their unhedged equivalents – while also suffering less volatility – and by utilising the support and specialist services offered by currency brokers the odds of seeing positive returns are increased still further.