Hedging Foreign Exchange Risks

Immediate and adverse currency rate movements may devastate cash flows and reserves for sovereign nations, multinational corporations, and private investors alike.

As a buyer of overseas goods, you will lose purchasing power alongside a weakening domestic currency. Alternatively, exporters become less competitive as the home currency strengthens, which makes for more expensive prices in foreign markets. Sophisticated traders employ various combinations of diversification, derivative, and swap tactics to mitigate foreign exchange risks.

Diversification

Statistical models show that owning uncorrelated assets improves probabilities for investors to turn profits across multiple economic scenarios. A diversified currency portfolio may include both United States and Canadian dollars.

We may expect these two currencies to trade against each other primarily according to government spending, energy prices and relative interest rates. The U.S. Dollar now buys 1.36 Canadian after these two currencies achieved parity in 2011.

Large corporations, such as Nike, Coca Cola, and Apple aggressively expand into overseas markets. Multinationals exploit arbitrage opportunities in foreign exchange, borrowing, and lending to further grow profits. Smaller investors may purchase individual stocks or global mutual funds to participate.

Foreign Exchange Derivatives

Derivatives are structured to lock in a particular currency rate through a set time frame. Options and futures contracts trade on organized exchanges like the Chicago Mercantile Exchange.

Options and futures are thus highly liquid, or more so easily convertible into cash. As the name would imply, options grant you the choice to receive or deliver currency at a locked exchange rate through a future date. Futures, however, are binding agreements.

Forwards are private arrangements between parties to trade currency at an established rate into the future. Forwards allow for high levels of customization, but do not trade on organized exchanges. Forwards are all but impossible to exit.

Currency Swaps

Swaps may best be described as agreements for separate institutions to settle each other’s financial obligations. Currency swaps feature two parties that exchange payments in different currencies. Currency swaps are typically combined with interest rate swaps, which also substitute fixed and floating-rate payments.

Swaps are especially important hedging tools for overseas credit transactions. For example, a money center bank that loans money out in yen may facilitate swaps to effectively establish set exchange and interest rates for the yen principal repayment.