Business

How To Hedge Currency Risk

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It’s important to know as an exporter or an importer. International business has become the driving engine of economic growth, and those that master the skills of multinational finance and access to credible Trading Platforms will have a better chance at long term survival than those businesses tied only to domestic sales.

International sales channels are important to your business because of the impact of business cycle smoothing. Strength in foreign currencies makes your products relatively less expensive than in prior buying periods. Having a means of offering international sales can boost your top line just when your domestic customers are feeling the pinch. The trouble then is negotiating with foreign distributors about how payments will be made. In the days of the past, US Dollars were the globally accepted means of payment, and US products were demanded enough by foreigners that distributors were willing to take on foreign exchange risk in order to supply demand.

That isn’t so much the case today. The question then is how to hedge currency risk when your distributors demand payment in foreign currency. Seems to me you have three choices: stop selling overseas (a disaster), give up significant terms on pricing in order to receive US dollars (a margin killer), or learn how to hedge currency risk (become proficient at multinational business).

What Choices Does a Business Have to Receive Payments with Reduced Exchange Rate Risk?

A business has several choices it can make in order to reduce exposure but still offer reasonable payment terms to international customers. Most sales contracts these days are set with some sort of “range-bound” commitment in order to simplify payments and reduce the costs of hedging (which can be expensive). An example of a range commitment might be that the price of a widget would be fixed (say five euros @ $1.41/EUR or $7.05) so long as the EURUSD exchange was between $1.40 and $1.45 (today it stands at $1.4149). Outside that range, the price would adjust up or down (in dollar terms) based on the prevailing rate at the time of payment (say 30 or 60 days). If the exchange drops to $1.39, the Euro buyer pays five euros and the business receives $6.95, a modest forex loss of 1.4%. If your margin is only 10% however that can really take a significant bite out of profits.

How to hedge currency risk in this case? One possibility to look at is to purchase a fixed dollar amount one-touch options contract. This would kick in a fixed yield profit if at any time the foreign exchange rate crossed below $1.40/EUR. But you might say to me, “Steve, I have no power to set the range on one-touch options contracts – I have to take what I can get!” That is where good negotiation and planning come in. When you are on the phone negotiating with your foreign business partner you need to have your trading screen up and KNOW the current month range options pricing. That way you OFFER a range forex price to your customer based on the currently available one-touch option contracts. If the bottom end of the one-touch contract is $1.3875 and you offer a range of $1.3875 – $1.45, then you have loss exposure from $1.41 to $1.3875, below that your contract ends in the money and you receive a profit from your hedge. Given the yields on contracts of this type and duration can reach 400%, you don’t have to hedge anywhere near the full amount of the purchase, only the maximum amount of potential loss.

In our initial example, this would mean hedging $0.10 per widget sold. If 10,000 widgets are sold and $1000 protection sought, a 200% yielding monthly one-touch options contract would require only a $500 investment to insure the potential currency loss down to $1.3899. Your business would now know how to hedge currency risk without engaging in expensive futures contracts for the full dollar value of the sale ($70,500). This would not be a full hedge, mind you (exchange rates below $1.39 still impact profits, albeit at a sales price $0.10 higher than it would otherwise be), but it can be a cost-effective, low maintenance alternative to futures. There is no set way how to hedge currency risk, using binary options is just one new way available on the major foreign exchange pairs.

James

James Deakin lives in California USA. He is an author of two famous novels, Rage of Angels and When Tomorrow comes. He is also the founder of classof2k9.com