Foreign exchange hedge
A foreign exchange hedge is a type of financial derivative, which gives companies a means of eradicating, or “hedging”, their cash flows against foreign exchange risk. The most popular hedging products include forward contracts, futures and options.
There are many different types of forward contract, though the most basic offers a company the opportunity to “lock in” the exchange rate of the day for settlement on an agreed future date. This safeguards the company against a fall in the exchange rate, however, it also means that any favourable change will not be applied. It is a simple yet highly effective method employed widely to hedge against foreign exchange volatility risk.
A hedging “option”, or foreign exchange option, allows a company to set an exchange rate price that it may wish to activate to conclude a transaction at a pre-agreed future date. However, if the exchange rate is better than this pre-agreed rate, the company is not obliged to exercise the set rate chosen under the foreign exchange option. Essentially, options are a fall-back function, ensuring the company that they will get a guaranteed minimum exchange rate.
Hedging forms a vital component of FX risk strategy, and if a company has operations across borders, failure to effectively hedge can result in huge losses in currency exchange.