How To Hedge Foreign Currency Risk

How To Hedge Foreign Currency Risk

As has been stated already, the foreign currency hedging needs of banks, commercials and retail forex traders can differ greatly.  Each has specific foreign currency hedging needs in order to properly manage specific risks associated with foreign currency rate risk and interest rate risk.

Regardless of the differences between their specific foreign currency hedging needs, the following outline can be utilized by virtually all individuals and entities who have foreign currency risk exposure.  Before developing and implementing a foreign currency hedging strategy, we strongly suggest individuals and entities first perform a foreign currency risk management assessment to ensure that placing a foreign currency hedge is, in fact, the appropriate risk management tool that should be utilized for hedging fx risk exposure.  Once a foreign currency risk management assessment has been performed and it has been determined that placing a foreign currency hedge is the appropriate action to take, you can follow the guidelines below to help show you how to hedge forex risk and develop and implement a foreign currency hedging strategy.  

A.  Risk Analysis:  Once it has been determined that a foreign currency hedge is the proper course of action to hedge foreign currency risk exposure, one must first identify a few basic elements that are the basis for a foreign currency hedging strategy.

1.  Identify Type(s) of Risk Exposure.  Again, the types of foreign currency risk exposure will vary from entity to entity.  The following items should be taken into consideration and analyzed for the purpose of risk exposure management: (a) both real and projected foreign currency cash flows, (b) both floating and fixed foreign interest rate receipts and payments, and (c) both real and projected hedging costs (that may already exist).  The aforementioned items should be analyzed for the purpose of identifying foreign currency risk exposure that may result from one or all of the following: (a) cash inflow and outflow gaps (different amounts of foreign currencies received and/or paid out over a certain period of time), (b) interest rate exposure, and (c) foreign currency hedging and interest rate hedging cash flows.

 

2.  Identify Risk Exposure Implications.  Once the source(s) of foreign currency risk exposure have been identified, the next step is to identify and quantify the possible impact that changes in the underlying foreign currency market could have on your balance sheet.  In simplest terms, identify "how much" you may be affected by your projected foreign currency risk exposure.

3.  Market Outlook.  Now that the source of foreign currency risk exposure and the possible implications have been identified, the individual or entity must next analyze the foreign currency market and make a determination of the projected price direction over the near and/or long-term future.  Technical and/or fundamental analyses of the foreign currency markets are typically utilized to develop a market outlook for the future. 

B. Determine Appropriate Risk Levels:  Appropriate risk levels can vary greatly from one investor to another.  Some investors are more aggressive than others and some prefer to take a more conservative stance.

1.  Risk Tolerance Levels.  Foreign currency risk tolerance levels depend on the investor's attitudes toward risk.  The foreign currency risk tolerance level is often a combination of both the investor's attitude toward risk (aggressive or conservative) as well as the quantitative level (the actual amount) that is deemed acceptable by the investor.

 

2.  How Much Risk Exposure to Hedge.  Again, determining a hedging ratio is often determined by the investor's attitude towards risk.  Each investor must decide how much forex risk exposure should be hedged and how much forex risk should be left exposed as an opportunity to profit.  Foreign currency hedging is not an exact science and each investor must take all risk considerations of his business or trading activity into account when quantifying how much foreign currency risk exposure to hedge.

C.  Determine Hedging Strategy:  There are a number of foreign currency hedging vehicles available to investors as explained in items IV. A - E above.  Keep in mind that the foreign currency hedging strategy should not only be protection against foreign currency risk exposure, but should also be a cost effective solution help you manage your foreign currency rate risk.

D.  Risk Management Group Organization:  Foreign currency risk management can be managed by an in-house foreign currency risk management group (if cost-effective), an in-house foreign currency risk manager or an external foreign currency risk management advisor.  The management of foreign currency risk exposure will vary from entity to entity based on the size of an entity's actual foreign currency risk exposure and the amount budgeted for either a risk manager or a risk management group.

   

E.  Risk Management Group Oversight & Reporting.  Proper oversight of the foreign currency risk manager or the foreign currency risk management group is essential to successful hedging.  Managing the risk manager is actually an important part of an overall foreign currency risk management strategy.

 

            Prior to implementing a foreign currency hedging strategy, the foreign currency risk manager should provide management with foreign currency hedging guidelines clearly defining the overall foreign currency hedging strategy that will be implemented including, but not limited to: the foreign currency hedging vehicle(s) to be utilized, the amount of foreign currency rate risk exposure to be hedged, all risk tolerance and/or stop loss levels, who exactly decides and/or is authorized to change foreign currency hedging strategy elements, and a strict policy regarding the oversight and reporting of the foreign currency risk manager(s).

 

            Each entity's reporting requirements will differ, but the types of reports that should be produced periodically will be fairly similar.  These periodic reports should cover the following: whether or not the foreign currency hedge placed is working, whether or not the foreign currency hedging strategy should be modified, whether or not the projected market outlook is proving accurate, whether or not the projected market outlook should be changed, any changes expected in overall foreign currency risk exposure, and mark-to-market reporting of all foreign currency hedging vehicles including interest rate exposure.

 

            Finally, reviews/meetings between the risk management group and company management should be set periodically (at least monthly) with the possibility of emergency meetings should there be any dramatic changes to any elements of the foreign currency hedging strategy.