(Due to the large fluctuations we’ve had in foreign exchange rates recently, I invited Heather Johnson to contribute this post. Contact information is at the bottom of the article. Thanks, Heather.)
multi-national companies that conduct trade around the globe and do so in a
number of currencies have known for decades the importance of hedging Forex
risk. These corporations have millions
or even billions of dollars to lose if they underestimate the importance of
this practice, so they have led the way in this field. However, big businesses aren’t the only one
who can benefit from an examination of their dealings in foreign currency. Even the smallest companies should start
hedging Forex risk if they have any international commerce. Though the amount of money at stake is
probably smaller than that of larger enterprises, the effect that a loss due to
Forex naiveté can have on a small business can be devastating. Here then are four signs that you should
start hedging your company’s Forex risk.
- When you have substantial foreign investment exposure: Many companies, including small businesses, look to foreign investments simply as a way to diversify their portfolios. Other, more aggressive companies often seek out foreign investments as a way to receive larger returns in an economy that they believe to be more robust than their domestic economy. These can be useful and successful strategies, but any enterprise following this route must take into account the risk involved with investment in foreign stocks. When a company invests in a foreign stock, they are not only taking on the speculative risk involved with any such investment, but they are also exposing themselves to foreign exchange rate risk. Even if a company achieves a speculative profit because of the increase in price of a foreign stock, the investment could actually sustain a net loss. This could happen if a devaluation of the foreign currency takes place between the period that the company purchased the stock and when they sell it. Therefore, it is important to place a foreign exchange hedge to help manage the Forex risk that accompanies any foreign investments.
- When you have substantial interest rate risk exposure: To help explain how interest rates can affect your Forex exposure, let’s first examine how arbitragers deal with them. Arbitragers are investors who attempt to take advantage of interest rate differentials between the foreign exchange spot rate and either the forward or futures contract. They can work either end of this equation, when they feel that one of these is either to high or too low. A simple example of how an arbitrager can make money doing this is by selling when the carry cost he can collect is at a premium to the actual carry cost of the contract sold. In this way, arbitragers can make huge profits from even small price discrepancies due to interest rate differentials. If money can be made from these differentials, then money can be lost if you are not paying attention.
- When you have substantial foreign exchange rate exposure: Even when conducted in relatively small amounts, buying or selling of any goods or services which are denominated in foreign currencies can immediately expose you to a substantial foreign exchange rate risk. Therefore, some foreign exchange rate risk exposure is common to almost all that conduct even a small amount of international business. When conducting these transactions, a firm price must usually be quoted ahead of time for the contract. This quote will be given using a foreign exchange rate that is deemed appropriate at the time, but this does not mean that the foreign exchange rate will be the same at the time payment is received. To manage this foreign exchange rate risk, it is best to place an appropriate foreign exchange hedge.
- When there is the potential for substantial losses or gains: The final time when a hedge
should be placed is when there is the maximum potential to either lose or make a lot of money; the difficult part is figuring out when this is. For example, if a currency is lower than it has ever been in your lifetime, it is probably not the best time to hedge further losses. However, it might be an excellent time to hedge upside risk on this fallen currency. With the recent decline in the US Dollar, this is something that all companies, even the smallest ones, should take into account when
considering how to hedge their Forex risk. A good hedge could put you on the road to prosperity, while a hedge in the wrong direction (or no hedge at all) could put you out of business.
Heather Johnson is a freelance finance and economics writer,
as well as a regular contributor for CurrencyTrading.net, a site for currency trading and forex trading
information. Heather welcomes comments and freelancing job inquiries at her
email address firstname.lastname@example.org