An Overview of Financial Derivatives Used to Hedge Foreign Currency Risk
Minneapolis, MN |December 10, 2024 | By: John Trefethen, Director and Co-Founder
Many companies engaging in international trade use foreign exchange (FX) hedging to mitigate the risks posed by fluctuating foreign exchange rates. In this article, we explore financial derivatives and how they’re used in FX hedging.
Companies that do business internationally are exposed to the risks associated with transacting in multiple currencies, known as FX risk. When left unmanaged, FX risk can lead to many problems, including:
Variability in profit margin through effects on cost and/or revenue
Uncertainty in pricing strategy
Uncertainty in budgets and strategic planning
To combat these risks, many organizations hedge FX risk using financial derivatives.
What is a Financial Derivative?
A derivative is a contract that derives its value from an underlying asset, index, or rate used to trade financial risk. Derivatives can be used for many different purposes, including risk management (hedging), speculation, and arbitrage.
This article will focus on the risk management perspective of FX hedging.
The 4 Most Common Derivatives Used in FX Hedging
In each of the following sections, you’ll find a definition, common use cases, the pros and cons, and a basic example associated with each of the most common FX derivatives.
#1: Forward Contracts
Forward contracts are over-the-counter (“OTC”) agreements between the hedging company and a counterparty to exchange two currencies at a specified future date.
Use Cases
Used to lock in favorable exchange rates for future transactions.
Ideal for exporters, importers, and any other international businesses with predictable cash flows in foreign currencies.
Pros
Forward contracts protect against adverse currency movements.
Terms of a forward contract can be tailored to the needs of the company (e.g. amount, date, and currency).
Cons
The company is obligated to fulfill the contract even if the market moves to rates more favorable at the time of execution.
Some forward contracts may require a margin deposit, which impacts liquidity.
Example
A US-based exporter expects to receive €500,000 in three months. The exporter enters into a forward contract to sell euros and buy USD (its functional currency) in three months, which locks in the future exchange rate for the company on the transaction date. This ensures a known, predictable, functional currency equivalent amount of the foreign currency revenue.
#2: Futures Contracts
While less common than forward contracts, futures contracts operate similarly. The primary difference between forwards and futures is that futures contracts trade in standardized terms and are traded through an exchange rather than directly with the counterparty.
Use Cases
Since they are exchange-traded, they are ideal for companies with less tolerance for counterparty risk.
Futures contracts are most popular among companies transacting in relatively smaller quantities.
Pros
Prices are determined in regulated exchanges, meaning everything is transparent.
Futures contracts generally have higher liquidity than OTC contracts, such as forwards.
Cons
Factors like contract size and expiration dates are predetermined, so there is limited room for customization.
Futures require an initial margin in addition to a daily maintenance margin.
Example
A multinational corporation purchases a number of future Euro contracts to hedge against USD/EUR exchange rate fluctuations over the next quarter. The benefit, relative to the notional equivalent amount of futures contracts, is the same as using a forward contract (ignoring differences in transaction costs) in that a known exchange rate is achieved for a forecasted transaction in a foreign currency.
#3: Options Contracts
Another common instrument used to hedge FX risk, options give the buyer the right—but not the obligation—to exchange currency at a specified rate or before a specific date. This discussion focuses on the use of OTC options rather than exchange-traded options (which, like futures, are standardized in terms of expiration, etc.). Options can be broken down into two types:
Call Options: The right to buy currency.
Put Option: The right to sell currency.
Use Case
Options are ideal for companies looking to maximize opportunity in their hedging and risk management strategy while providing protection against unfavorable exchange rate levels. Options provide companies with the right, but not the obligation, to exchange currencies in the future at a pre-determined rate (the strike rate).
Pros
Options are highly flexible in their terms, from the notional amount to strike rate to expiration.
Options provide upside potential. If the market rate at the time of expiration is favorable, the company can let the option expire without settlement (exercise).
Con
Options require an upfront premium cost that can be prohibitive depending on market conditions and the desired rate at which to obtain protection (the strike rate).
Example
A US-based importer purchases a call option to buy EUR at $1.05 per EUR, ensuring stability in costs even if the USD weakens. If the exchange rate at the time of option expiration is $1.04 per EUR, the company would not exercise the option and simply buy EUR at the spot rate of 1.04, which requires less USD per EUR. On the other hand, if the exchange rate at expiration is $1.06 per EUR, the company would exercise the option and receive 0.01 of compensation from its counterparty. This would result in a net exchange rate of 1.05 (purchase EUR at 1.06 in the market and receive 0.01 of benefit from the option).
#4: Currency Swaps
Currency swaps are contracts that allow two parties to exchange cash flows or obligations in one currency for cash flows or obligations in another currency.
Use Case
Currency swaps are most commonly used by multinational corporations for long-term exposure management when investing and/or operating in foreign markets.
Currency swaps allow companies to take advantage of favorable lending conditions in foreign jurisdictions.
Pros
Swaps allow businesses to secure borrowing terms in foreign currency.
They reduce long-term currency risk.
Cons
Swaps require expertise to structure effectively—they can be complex.
Transactional costs are high.
Example
A U.S.-based company with operations in Japan enters into a currency swap to convert its yen-denominated debt into dollars, reducing exposure to exchange rate volatility. This allows the company to borrow in the local currency when it is beneficial while providing stability in its functional-currency equivalent cost of funding for the enterprise.
Derivatives Manage FX Risk with Hedge Accounting
These four derivatives are great tools of the trade that help organizations meet the goals of their risk management strategy, but issues can arise when accounting for them in your balance sheet.
If your organization is hedging FX risk using any of the above financial derivatives, you are required to do mark-to-market (MTM) accounting for that hedge. As that hedging contract gains or loses value, you recognize an unrealized gain or loss every period you’re recording your financial statements. If you have a contract that matures 12 months from now, you have 12 months of market volatility that will impact the bottom line over the next few quarters.
That’s why many organizations elect to use hedge accounting, which provides preferential treatment for derivatives formally designated and documented as highly effective hedges. Hedge accounting aligns the recognition of gains and losses on the derivative with the hedged exposure in earnings, mitigating the effects of market volatility from period to period. This provides a proper alignment of gains and losses both in timing and financial statement geography, resulting in the financial statements reflecting the economics and intention of the hedging strategy. This application allows companies to take credit for effective risk management practices rather than needing to provide an explanation of the effect of unrealized gains and losses from derivatives on financial performance.
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Author: John Trefethen, Director and Co-Founder
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Email: jtrefethen@hedgestar.com
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