Finance

What You Need To Know About Foreign Exchange Hedging

Many companies are exposed to currency risk, whether they realize it or not.

If your company sends or receives payments in foreign currencies on a regular basis, you could be impacted by exchange rate risk (also known as currency risk), which arises from fluctuations in the value of a base currency against a foreign currency.

When currency exchange rates fluctuate, businesses use hedging strategies to prevent losses. Hedging minimizes a company’s exposure to potential risk.

What Is Hedging?

Hedging is the act of strategically opening multiple positions in order to protect against adverse movements in the foreign exchange market. Put simply, foreign exchange hedging involves opening a position on a currency pair that counteracts negative price movements in another currency pair.

How Hedging Can Reduce Currency Risk

Companies use forex hedging to eliminate their foreign exchange risk arising from foreign currency transactions. Companies that conduct business in multiple countries need to deal in foreign currencies.

When such companies deal with receivables and payables, they do so at the current exchange rate. However, there are high chances that the exchange rate may change unfavorably before the payment is made or received. Forex hedging can help mitigate such risks.

Forex hedging can be considered a risk management solution that helps you manage your business and mitigate volatility in the foreign exchange market. It is like an insurance policy that protects your business against market fluctuations that could affect your costs as well as revenue.

Do Banks Offer Forex Hedging?

Yes, forex hedging solutions are offered by premium UAE banks such as ADCB, which offers a wide range of risk management solutions, including FX Spot, FX Forward, FX Options, and more. Below are some of the most common hedging strategies that companies can consider.

Forex Hedging Strategies

FX Spot

A spot foreign exchange rate is the rate of a foreign exchange contract for immediate delivery (normally occurs one or two business days from the trade date). The spot rate reflects the price that a buyer expects to pay for one currency to purchase another currency.

FX Forward

A forward rate is a rate quoted for transaction and settlement for any day after the spot date.

A forward contract is used to protect a business against volatility within the currency rate. This hedging strategy allows you to buy a currency on an agreed future date and at a fixed exchange rate.  By fixing your exchange rate, you will be protected against any fluctuations in the market.

Flexible FX Forward

A flexible forward is a type of forward contract that offers businesses more flexibility to settle the contract partially or fully at various dates up to maturity.

Flexible forward contracts are particularly useful when a company expects to make or receive a series of payments with uncertain dates and\or amounts.  For example, a company may wish to buy a flexible forward if it pays salaries to employees overseas.

The Bottom Line

Hedging is one of the most effective ways to minimize the impact of unexpected exchange rate fluctuations in the foreign exchange market, thus making cash flows more stable and predictable. When done correctly, hedging can help businesses better estimate their income, taxes, and ultimately revenue.

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