Dynamic Hedging is a foreign exchange management strategy that provides a flexible solution to protect investments from exchange rate risks as it allows businesses and individuals to readapt their hedging positions to evolving market conditions.
The Dynamic Hedging strategy differs to more static currency management schemes as they allow to readapt the hedging rate in parallel with the evolution of the FX markets.
This strategy, applied to international businesses exposed to FX volatility, allows them to hedge their exposure at rates that are closer to the current exchange rate.
For instance, businesses selling goods and services overseas and with prices in foreign currencies face continuous exposure to the fluctuations in the exchange rates of those currencies.
The company has two options to protect their margins:
- Pre-Hedging: The company sets their products prices in foreign currency, according to a target exchange rate and hedges in advance their estimated sales volume for a defined period that might be a season or a year. This strategy guarantees steady margins for the company during the whole season, but it does not allow them to re-adapt the prices during the season, which might lead to a loss of competitiveness.
- Dynamic Hedging: The company sets the price at the daily exchange rate and hedges the accumulated sales at the end of the day or when its exposure volume reaches a certain level. That way, the company has hedged all their exposure at the current exchange rate (and with a minimal differential with their target rate). With their exposure back to zero, the company might maintain their prices if the exchange rate remains steady or they change it to preserve their profit margins in case the exchange rate moves.
Some companies, working with fixed prices or a seasonal catalogue are forced to pre-hedge if they do not want to put their profits at risk. However, more digital businesses like online travel agencies, marketplaces or others with internet-based sales platforms can change their prices regularly and are more interested in dynamic hedging solutions that allow them to take advantage of favourable fluctuations of the exchange rate and protect them from the inconvenient ones.