A Fresh Approach to Currency Hedging p.2

In our last instalment we discussed the scenario of ‘not hedging’ or ‘zero protection’. Today we are going to look at the flipside of the coin… 100% protection. It sounds attractive already but be sure to remember that 100% certainty does come with its own trade-offs. Let’s take a look.
Quick Recap
Remember last week we discussed how by paying overseas using spot-only you are exposing your business to 100% risk while receiving 100% upside opportunity. Here is the picture that tells a thousand words...
This week we look at the opposite in protection and opportunity, which are Forwards Exchange Contracts (FEC’s).

But first, what is a Forward?
Forwards are the most widely used form of hedging for your currency exposure and the topic of discussion today. By taking out a Forward you are locking in 100% protection for the amount of the contract.

A Forward is simply a contract between you and your currency provider, whereby you agree to purchase (or sell) an agreed amount of foreign currency at an agreed rate, on an agreed date (called the expiry).

Quick Example
You wish to pay an invoice of USD97K within 45 days. Today’s spot rate is 103.7 cents. The forward rate is 103.3 cents. Thus, we buy a Forward with an expiry 45 calendar days away, and lock in 103.3c as the rate. This means that we can pay this above invoice any time from now until expiry at 103.3c regardless of whether the spot rate moves up or down. In fact, some Forex providers will pay you back the ‘forward points’ when you settle earlier.

From this example you can see that by locking in an exchange rate, we have now protected ourselves against the market falling away before the actual day that we pay the invoice. If the market is at 91.3c on the day we pay the invoice, we still pay at 103.3c thanks to the Forward. This means we have installed protection against a fall in the rate.

You should also note that if the rate now goes up, we can no longer take advantage of the better rate.  If the spot rate is trading at 115.3c on the day we pay the invoice, we still have to pay the invoice at 103.3c. Unfortunately, we’ve missed out on upside opportunity due to locking in the exchange rate with a Forward. In this scenario, the peace of mind of having protection has cost us dearly in upside potential.

Here is a graphical representation of what forward protection may look like :
100% Protection, Zero Opportunity

There are a number of observations here…
  1. It is obvious that when you take a Forward that you ‘give-up’ the forward points. This is the interest rate differential denoted by the downward arrows.
  2. We can see that even where the spot rate heads up, we have ‘zero opportunity’ to participate in this better rate, because we have locked in a worse rate within our Forward Exchange Contract with our currency provider.
  3. We can also see that wherever the rate goes below 103.3c, we have ‘100% Protection’ because of our Forward. This adds peace of mind to our worst case rate, knowing that we can make a predetermined profit on this shipment.
To summarise:
FORWARD EXCHANGE CONTRACTS  =  100% Protection with Zero Opportunity
Let’s compare this to last week’s discussion on ‘spot-only’ payments…
SPOT-ONLY PAYMENTS =  100% Opportunity with Zero Protection

So in theory we have just proved that locking forward contracts is the polar opposite to making spot-only payments when we are considering our overseas payments. But which is safer?
Unless we know which way the currency market is about to move, neither is a better strategy. They are both speculative in the sense that with a spot-only strategy we are hoping for the rate to increase and for a Forward strategy we hope that the rate diminishes.

What’s next?
In our next article we shall discuss strategies that allow you to hedge your currency exposure that can give you 100% protection, while also enjoying upside opportunity simultaneously.
Once again, this sounds like the silver bullet you were looking for, right?
Let’s just wait and see…

General Disclaimer :  All ideas, opinions, recommendations and/or forecasts, expressed or implied herein, are for informational and educational purposes only and should not be construed as financial product advice or an inducement or instruction to invest, trade, and/or speculate in the markets. All trading and investing activities are subject to the usual market fluctuations that may result in gains and losses. Any action or refraining from action; investments, trades, and/or speculations made in light of the ideas, opinions, and/or forecasts, expressed or implied herein, are committed at your own risk and consequence, financial or otherwise. Please seek legal and/or financial advice before taking or refraining from such action. Past or historical results may have no bearing of current or future trading or system results.

By Marcus Addison
Marcus Addison has over 15 years of experience in currency markets. He has worked in eTrading for the largest FX provider in the world, Deutsche Bank and has traded both as a Hedge Fund Manager and as a professional Proprietary Trader for the largest electronic derivatives group in Europe. He now focuses on using his trading and foreign exchange experience to help both importers and exporters wade through the currency maze with Addison Capital.