Reducing risk by implementing a foreign exchange hedge
A foreign exchange hedge is a method used by companies to eliminate or ‘hedge’ their foreign exchange risk resulting from transactions in foreign currencies. This is done using either the cash flow hedge or the fair value method.
When companies conduct business across borders, they must deal in foreign currencies. Companies must exchange foreign currencies for home currencies when dealing with receivables, and vice versa for payables. Foreign exchange risk is the risk that the exchange rate will change unfavourably before payment is made or received in the currency. For example, if an Australian company doing business in the United States is paid US dollars then that company has risk associated with fluctuations in the value of the US dollar versus Australian dollar.
A hedge is a type of derivative, or a financial instrument, that derives its value from an underlying asset. Hedging is a way for a company to minimise or eliminate foreign exchange risk. Two common hedges are forward contracts and options.
A foreign exchange hedge transfers the foreign exchange risk from the trading company operating their business to a bank or other financial institution that will carry the risk. The banks of course charge the company for setting up a hedge. In addition, by setting up a hedge, the company also forgoes any profit if the movement in the exchange rate would be favourable to it.