There are multiple financial instruments that can be used to hedge FX risk: forwards, futures, options and even combinations of different products.
FX forwards are the most common products used for hedging. FX Forwards enable you to fix the exchange rate of currencies for a predetermined period of time (until maturity date). Any profit/loss on the expected cash flow arising due to a change in FX rate changes will be compensated by a loss/profit arising from a forward position and vice versa. Alternatively, businesses that want to keep the upside that can arise from currency moves can choose options to hedge their risks.
Options are a more complex tool to offset a loss from FX move. Options allow FX traders to buy or sell a currency at a specified price, known as a strike, and can be exercised at a specific, predetermined point in time. If the reference exchange rate drops sharply, an option gives the owner to sell a currency at a preset price (strike) – known as a put option. This way, when business needs to sell currency, it exercises the option and sells currency at a better exchange rate that is on offer in the market – avoiding a loss. On the other hand, if the exchange rate rises in favour of the option owner, the business will choose to let option expire and convert its cash flow at a more favourable exchange rate in the market.
As everywhere, perks have a price. And the price is known as the option “premium”. This can make hedging solutions that embed options quite expensive. Nevertheless, sophisticated hedging strategies can be designed using a combination of different financial instruments.
For instance, the Brazilian company could buy an option which will payoff when the real strengthens against the dollar. If the dollar weakens, the option will offset some of the losses arising from a less favorable exchange rate.
The concept of ‘FX risk’ itself is rather straightforward, especially when the context covers only a single currency pair. However, within many international businesses, cashflow risks arising from costs, revenues as well as their timing often create complex problems for managing them, both from financial risk and operational perspective. For example, a multinational corporation with multiple revenue sources and cost centres, must not only hedge the exchange rate risk, but also manage the timing (payment) risk of its cash flows, be aware and cautious of products it is using, currency settlement dates and simple things like data errors.
While at first sight FX risk might seem like a simple problem, each business, however, can be exposed to multiple scenarios with hardly predictable outcomes. At the end of the day, managing FX risk is not an easy job, and there is no foolproof method to do this in a complex environment.