Forex Hedging: How FX Hedging Works and When to Use it

If we take volatility to be synonymous with risk, it’s then understandable why investors and business owners pay a premium to help mitigate exposures to such volatility. For those with a large reserve of foreign currency or those who rely on foreign income, it’s important to not become subject to the tidal forces of FX price swings.

Predicting the direction of currency price swings isn’t just futile because it’s hard (or even impossible) but because it’s not necessary. Volatility comes with its ups and downs, and risk factors both of these in – not just the downs. It’s important to recognise early on that we have no edge in regards to predicting the direction of the market, so we settle for mitigating any and all fluctuations. 

To mitigate our exposure to these market fluctuations we can use hedging tools, which are becoming increasingly common among SMEs, freelancers, and expatriate retirees. Many people dream of how to become richest in the world by Forex trading.

How FX Hedging Works?

Hedging in general means offsetting risk. So, if we have already unwillingly bet on one team to win a game of football, we could bet on the other outcomes to control how much we could lose. Given that our risk surrounding currency is time – we don’t know what the price of our currency will be tomorrow – common currency hedging products involve contracts around time.

FX hedging works by locking in contracts around the future purchase or sale of a currency to ensure we have pre-agreed terms. These pre-agreed terms mean that from the time they’re agreed to the date they mature, you have a reduced exposure to the market.

Hedging has been big amongst large corporations and banks for almost two centuries, but it can be just as useful for small businesses too, particularly given we are more dependent on other currencies than ever before. Remote workers, freelancers, Amazon sellers, and expats are anticipating exchanging some money in the coming months, yet have little idea of what the spot rate will be by then. This makes it very hard to plan cash flow and control seemingly pointless losses of money.

There are other forms of FX hedging, like an option contract, in which you get the choice of whether you want to execute that purchase of Euros or not once the date arrives. This means you can avoid buying those Euros for a poor rate if the market has since swung in your favour. 

FX Hedging Example

So, a forward contract for Euros would be a matter of agreeing on the purchase of, say, €5,000 EUR in one month’s time for $5,400. This will be slightly worse than the current spot rate to account for the risk of the other party involved, but you have now locked in an agreement to buy these Euros in one month’s time. This is ideal if you know you’re going to need those Euros, but the market (perhaps due to the war, politics, or economics) is volatile. In a sense, this is like paying an immediate fee for insurance to cover a possible worst-case scenario.

You can also learn about what is automated Forex trading and how does it work for more informational purpose.

Who is Offering Hedging Products?

Because this isn’t a common practice among small businesses historically, as there were previously more obstacles to international trade and travel, UK banks and other traditional financial intermediaries have ignored this market entirely. With the democratisation of financial products and technology, it’s evident that SMEs and overseas remote workers are increasingly interested in using these hedging products but are forced to look elsewhere. 

You only have to search “HSBC forward contract” to see how inaccessible it is for everyday people, with their unfriendly and verbose PDF result coming up first in the results, which states one must put in a request with them to place FX transactions – but it may get rejected. Whilst SMEs may have a chance with HSBC, many other highstreet banks exclusively deal with large corporations.

If we compare this to FX specialists that have state-of-the-art apps and websites aimed at onboarding everyday people in an accessible way, it’s no wonder that alternative finance is blowing up right now – including small business loans. Whilst the leading money transfer companies like Revolut and Wise do not offer currency hedging, many of their close competitors do, like OFX and MoneyCorp.

Foreign Exchange Management

It has taken the FX specialists’ record revenues during times of instability to shine a light on the untapped demand for accessible sophisticated currency products. In response, some banks have been stepping up and reacting to the demand, but they nevertheless lag behind. Sudden changes in infrastructure, such as supplying these products over an app to everyday people, is difficult due to their weighty legacy systems in place.

Foreign exchange management is becoming an increasingly common puzzle to solve due to international business, be it the rise in remote workers or the ease of being an overseas marketplace seller. Unsurprisingly, it is the smaller specialists and tech startups that react first, with the bigger players following after, if at all. However, we are yet to see that if UK banks’ focus does shift enough on accommodating small businesses – though this is doubtful given their neglect of small business loans during the past decade – then we cannot rule out smaller specialists being squashed by their economies of scale and goodwill among the public. 

Alternatively, we may see the continued rise of not just democratized financial services but decentralization, with financial the Apps in blockchain networks now offering crypto loans and even hedging potential. After all, a forward contract is incredibly easy to execute with a piece of code given that it relies on few variables – just a countdown until the transaction is executed with pre-agreed terms.

Conclusion

It is crucial to understand that hedging is not a means of profit. A Forex hedging strategy is not intended to generate profits. Notably, the majority of hedges reduce exposure risk by a fraction, which can be costly and not always profitable. Hope you have now understood How fx hedging works and when to use it.

Originally posted 2022-04-12 03:00:00.


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