Hedging currency risk is an essential tool for businesses that work in several currencies because it helps them to manage their costs and forecast their profits.
Currency risk (also called foreign exchange risk or exchange rate risk) occurs when there is the potential for the price of one currency to change in relation to another. Small and medium-sized businesses that buy or sell across borders are often among the hardest hit by currency volatility.
The importance of a money market hedge grew in 2022 as the pound fluctuated widely. Political uncertainty led to a record fall against the US dollar and other factors – including the war in Ukraine and the ongoing pandemic – continued to affect currencies worldwide.
Economists are predicting that the pound will continue to perform poorly against other currencies in 2023. Patrick Locke, a global FX strategist with J.P. Morgan, argues that the UK has a bleak medium-term outlook. With more volatility on the horizon, now is a good time to consider ways to minimise potential losses.
What is currency hedging?
Currency hedging is a strategy used to limit your currency risk. The purpose of this strategy protects you from losses if the foreign exchange rate you are trading at changes unfavourably before your payment is made or received.
The best hedging strategy for your business will depend on the types of payments you make and receive, as well as your payment timeframes. There are a number of tools and contract types that businesses can use as part of the currency hedging strategy.
What is exchange rate risk?
Exchange rate risk is the risk that your business’s costs or profits can be affected by fluctuations in exchange rates. Exchange rate movements can mean costs or revenue from abroad fluctuate each month, both negatively and positively.
Businesses that buy and sell in other countries, send large sums of money overseas, or have staff, suppliers or customers abroad are exposed to exchange rate risk that can affect their bottom line. Exchange rate risk also affects investors with foreign assets in their portfolios, according to the US financial services company Morningstar.
UK businesses can face higher costs – and lower returns – when the value of the pound changes against other currencies.
Example | Hedging currency risk when importing goods
A UK-based agricultural business sources equipment from the United States. A piece of equipment priced at US$1,000 would have cost £739 on February 4, 2022 when the USD to GBP spot price was 0.739. Fast forward to September 23, 2022 when the pound fell to record lows against the dollar and the spot price was 0.921. The same piece of equipment would have cost £921 – a price hike of £182.
Similarly, you can be exposed to currency risk when receiving money from abroad.
Example | Hedging currency when exporting goods
A UK furniture manufacturer that sells its products in Europe may price a sofa at €5,000. On September 27, 2022, the EUR to GBP spot price was 0.895, netting the manufacturer £4,475. By December 10 however, the rate had fallen to 0.86, equating to just £4,300 – £175 less.
To minimise such risks, manage costs and increase the accuracy of forecasting, businesses that work in several currencies choose to limit their exposure to market volatility with a hedging strategy. A currency specialist such as Moneycorp (providers of the Telegraph Media Group Business Money Transfer Service) can help you to develop and implement this by taking on the currency exchange risk for you to protect you from losses.
How to hedge currency risk
If you are looking to create a currency hedging strategy, speaking to an expert such as a currency exchange specialist is the best way to get an effective and bespoke strategy for your needs.
However, there are some key tools to learn about:
1. Forward contracts
A forward contract allows you to buy or sell a fixed amount of currency at a pre-agreed rate and lock this rate in for up to two years for a scheduled payment.
It offers a degree of certainty when entering into contracts with customers or suppliers and can be an effective way to manage expected costs. A forward contract also provides budget certainty, so while there may still be unexpected costs on the horizon, it can be a way to mitigate some of the risk of currency fluctuations regardless of future exchange rate volatility.
Of course, while this helps protect you from drops in currency value, the exchange rate may also move in your favour, leaving your business locked into a lower rate. This possibility must be balanced against the risk of the pound dropping in value before you make your transfer. There are no guarantees, making it harder to plan and maintain margins.
Note: A forward contract may require a deposit and business clients may also need a suitable credit facility in place with the provider.
2. Market orders
If you don’t have a deadline for your money transfer you could put in a market order. This form of currency hedging enables you to identify a specific exchange rate. Once that is reached, the exchange is made.
It offers a little more flexibility than a forward contract and can be set up with an ideal highest specified rate and a lower acceptable rate to protect against significant losses. It offers a measure of budget certainty and lets businesses leverage the potential opportunity if the pound makes gains.
How a currency specialist can mitigate exchange rate risk
If your business has overseas costs or revenue, a currency specialist can help you protect your profits from market volatility and currency exposure. Currency specialist Moneycorp provides the Telegraph International Business Money Transfer Service. This gives you access to competitive exchange rates and a range of tools for making international money transfers and other payments over the phone and via a secure online platform 24/7.
There are a range of services available for businesses, including a free, no-obligation currency risk assessment and tailor-made strategy – your account manager will be on hand to address your business needs.
- Open an account today to get in touch with an expert currency specialist via the Telegraph Media Group International Business Money Transfers.
Read more:
Be aware of currency risk. You will receive payments in a different currency, so the final return you will get depends on the exchange rate between the two currencies.
Moneycorp is a trading name of TTT Moneycorp Limited which is authorised and regulated by the Financial Conduct Authority for the provision of payment services (firm reference number 308919). Date of Approval 07/03/2023
The above article was created for Telegraph Financial Solutions, a member of The Telegraph Media Group. For more information on Telegraph Financial Solutions click here.
Information correct at date of publication.
