Hedging is a financial instrument that individuals and companies can use to protect themselves against potential currency exchange risks on the market (example when imports, or local production, and export are executed in different currencies or vice-versa). This financial instrument is basically an agreement between an exporter and a bank whereby the exporter is guaranteed a definite rate of exchange upon presentation of a specified foreign currency at a predefined date. If a foreign currency position is hedged, the exporter is no longer subject to the currency risks associated with such position.
COMMON HEDGING TOOLS
The most frequently used hedging tools are:
- currency options
- forward contract
- futures contracts
Advice: Whenever possible, buy and sell in the same currency; if this is not possible, consult with a bank to cover any future currency exchange risk (appreciation or depreciation of buy/sell currency in the transaction).
Companies that have substantial international trading shall always have a clear strategy and process in place to make sure currency exchanges do not hurt their business. The main steps of a sound strategy are, as shown in the illustration below: identify the exposure, formulate a strategy (banks can support), hedge opens positions and monitor the currency exposure on a continuous basis.