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12 Jul 2013

Business Hedging against Currency Moves

Wild fluctuations in the currency market happen all the time, with banks, hedge funds, and speculators making and losing money everyday.  Despite increasing interest in trading the forex market, however, the vast majority of currency transactions take place through banks as businesses exchange goods and services on the international market.  Export and import operations across New Zealand depend on exchange rates all the time, with many businesses choosing to hedge currencies as a way to insure against violent and unexpected moves.

It is common for import and export profits to get lost in translation, with exchange rates moving all the time and even the most informed businesses at the whim of the market.  With importers effectively taking a bet the currency will stay high upon every transaction, and exporters doing the opposite, even small moves of a few percent can cost businesses thousands of dollars.  Hedging is an investment position designed to offset any potential losses, by making a companion investment often in the other direction of the primary transaction.  

While hedging currencies may seem like a complex business, there are a number of different ways for businesses to protect themselves from the market.  The simplest way for importers to hedge currencies is to open a bank account in the country they are importing from.  By doing this, businesses can send New Zealand dollars to their foreign account when the exchange rate is favourable, in effect locking in a rate for a future date.  Like all currency transactions, however, fluctuations are inevitable and timing them for profit is both an art and a science.

Along with spot rate conversions, businesses also have the opportunity to hedge currency through forward exchange contracts, futures contracts, foreign exchange options, and more complex transactions such as trade finance facilities and foreign currency overdrafts.  A currency forward contract is basically an agreement to exchange funds at a future date, enabling businesses to lock in a purchase or sale at the current rate.  While it is not possible to profit from favourable future moves this way, this type of contract allows businesses to lock in specific rates and set budgets accordingly.

Futures contracts are similar in many ways to forward contracts, establishing a commitment to purchase currency at an agreed upon rate through a reputable exchange.  In contrast to forward contracts, however, this class of transaction has a secondary market which enables businesses the flexibility of selling a contract before the term is up.  There is a price for this flexibility, however, with futures contracts defining a range of exchange rates rather than a fixed point.  Businesses can also use currency options through banks, which give an opportunity of a set price without an obligation.

Unlike the business of speculation, import and export businesses want a stable and known exchange rate above everything else.  While each of these currency hedging options comes with fees and commissions, and there is always a chance that the actual exchange rate will improve against your position, hedging allows businesses to set margins accordingly and get on with costing their operation based on known factors, not unknown fluctuations.