27 June 2012

Judicious use of FX orders to get hedging in place

We have always been strong advocates of using FX orders placed with bank counterparties as a preferred method of entering hedging - as opposed to the spot market rate.

Once a company with foreign exchange risks has decided to lift or reduce hedging percentages as part of their risk management strategy, value-enhancing market dealing tactics to get the hedging entered at more favourable exchange rates will add to the overall hedging performance. We have always been strong advocates of using FX orders placed with bank counterparties as a preferred method of entering hedging – rather than just dealing at the prevailing spot market rate at the time the “go” decision button is pushed.

Discipline is needed with FX orders

However, it pays to be highly disciplined in placing orders to deal at a predetermined rate , as it is with all aspects of currency management. FX order can either be “firm” (i.e. automatically transacted by the bank once the market spot rate reaches the order level) or “call first” where the bank dealer must call the company once the order level is reached and get prior confirmation before transacting.

Firm orders can either be “good until cancelled” or left in place until a stipulated time. It is important for control purposes that the company has a register of FX orders placed with all banks with a record of transacted. lapsed or cancelled.

We have also been fans of using a staggered series of orders for different amounts at selected exchange rates. Of course, the big risk in using orders to transact hedge entries is that the market rates never get to the order levels, move in the opposite direction and the hedging is never done!

Stop-loss orders

Many companies use a second “stop-loss” order above or below the order placed. In this way, the hedging is transacted whether market exchange rates move up or down. The instruction to the bank in using stop losses has to be an explicit “either/or”, the transaction is either dealt at the order level or the stop-loss level and when that happens the second order automatically cancels.

Like a lot of things in currency management, judgment is required of how close to place the order and related “stop-loss” to current market rates. That judgement depends on short-term exchange rate volatility, technical support and resistance levels and the skill of the bank dealer being used. Companies transacting hedging in this way have to accept that there will be times when the stop-loss is triggered and a less than optimal entry is achieved.

Constant monitoring is required and you may want to take a look at how Hedgebooks FX Exposure Tool works for this. However, we have never found the changing of order/stop-loss levels on a regular basis, once placed, is too value-enhancing. Set the targets and stick to them. Understand the risks if you place an order at a more favourable rate without a related either/or stop-loss on the other side.  For currencies that make their more significant movements in overnight markets, judicious use of FX orders makes a lot of sense.

Want to learn more about FX Risk Management – take a look at our overview of Effective FX Risk Management.

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