Guide to managing Foreign Exchange Risk - Forward Contracts
Financial markets are volatile and the major currency pairs have seen more movement than some of the emerging market currencies. So, when markets more against you, your profits could be wiped out. That's why managing your foreign currency risk is key
Hedging as a risk management strategy
Hedging means, basically, that you can eliminate the risk by pre-purchasing or selling the currency, so if rates change you won't be affected. For how long you can lock in our exchange rate depends on your financial services provider. With Tait Capital it's up to six years. The illustration below shows you how a forward contract locks in an exchange rate.
Hedging with Forward Contracts
Your risk appetite determines your hedging level. Very risk-averse businesses hedge their entire foreign exchange exposure. This has many advantages, such as being able to improve budgeting and planning as well as giving you peace of mind. It also means, however, that when the markets move in your favour you can't take advantage of the up-side.
Financial services providers like Tait Capital call clients when they see that the currency pairs they usually trade have moved in their favour and offer them spot transactions to take advantage of the movement.
Another strategy businesses often use is layering, which simply means that you buy your forward contracts at different times. So you start off buying a forward to cover your basics. If the market moves in your favour and your forwards for your currency pairs become cheaper, you buy another forward contract. That way you always eliminate the percentage of your currency risk while also taking advantage of different pricing levels due to market movements.
You generally have two options when it comes to forwards and whether a fixed or an open window forward contract is better for you depends on your drawdown requirements
1. Fixed Forward
A fixed forward contract allows you to agree an exchange rate today, for a fixed amount, to be used on an agreed date in the future (the value date). So if you know how much you need'll to spend in the future or what you'll be receiving from suppliers or subsidiaries, you can use a fixed forward to guarantee how much you'll pay or receive.
Also, if you pay bills or get paid in a foreign currency on the same day of each month, and the amount is always the same, you can use a number of fixed forwards, called layering or strip forwards, to guarantee the rate.
2. Open Window Forward
This tends to be the most popular forward because most businesses can't guarantee when their bills are due or when their customers or partners pay their invoices. Often the amounts also vary. With an open window forward you can draw down any amount at any time, up to the total value of the contact.
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