If it is not wise to always hedge via zero-premium collar options and you should never pay a premium to buy outright call and put currency options – what is the right approach?
Since it was first published in 2014 thousands have benefited from this blog’s common-sense approach to a common misunderstanding. It relates to the calculation of foreign exchange (FX) forward points.
Financial hedging involves buying and selling foreign exchange instruments that are dealt by banks and foreign exchange brokers. There are three common types of instruments used: forward contracts, currency options, and currency swaps.
Managing this FX risk faced by importers and exporters all over the globe today is a three-step process: identify FX risk; develop a strategy; and utilized the proper instruments/strategies to hedge the risk.
Many small- and medium-sized firms engaging in import and/or export activity tend not to hedge. The reasons not to hedge come in all shapes and sizes: it’s too complex; it’s too costly; there’s a misconception that it is speculation; or even that that firms don’t know about hedging tools and strategies available to them.
Importers and exporters alike face foreign exchange risk, or currency risk, when engaging in economic activity outside of their domestic currency. As explained in an earlier blog post, currency risk materializes for exporters when exchange rate volatility results in the company repatriating fewer revenues abroad, when the domestic currency strengthens relative to the foreign currency. For importers, this risk is the exact opposite: currency risk materializes when the domestic currency weakens relative to the foreign currency.
Import and export companies face the daunting task of dealing with foreign exchange risk that can easily alter revenues from overseas; with smaller cash reserves, exchange rate fluctuations can be the difference between profits and losses.