Currency Hedging Primer

Why Hedge?

More and more companies are faced with the problem of how best to deal with currency exposure. This is no longer an issue faced only by large multinational corporations. Increasingly, small firms and even individuals are faced with the same problem: signed contracts or purchases in a different currency that take place in the future may result in unplanned cost if the currencies fluctuate unfavorably. Smaller companies and individuals are more than likely to ignore the issue and concentrate on the business at hand. But it can become costly.

It is important to use a hedging strategy to eliminate currency exposure and the attendant risk associated with currency movement. Luckily, a number of vehicles for hedging forex risk exist. They all either involve finding a way to buy foreign currency now at today's exchange rate (so you know what your costs are and have a sound basis on which to set the price of your product/service), or finding a way to gain the right to buy foreign currency at a later date at today's fixed exchange rate.

Hedging allows you to manage the risk and reduce potential risk. If you don't hedge, it's tantamount to speculating that the foreign currency rate will stay the same. If the rate ends up moving unfavorably, your speculation can be costly.

A Scenario

We'll go through several hedging vehicles using the following scenario:

Scenario: As a U.S.-based company, you sign a contract where you have to pay EUR 500,000 in six months. Suppose the current EUR/USD rate is 1.50.

Remember that this scenario could equally apply to a contract due in six months, a parts purchase delivered COD in six months, or a European property closing in six months. The principles are the same, and could apply equally to both the payer and the payee.

How much is this EUR 500,000 really going to cost you in USD? It will depend on the exchange rate fluctuations over the next 6 months. Using this scenario as an example, we will briefly review five hedging solutions available today:

• A: Euro Bank Account
• B: Currency Forward Contract
• C: Futures Contract
• D: Currency Options
• E: Carry spot trading using OANDA FXTrade

Solution A: Euro Bank Account

At a major bank:

• Open a Euro account;
• buy EUR 500,000 and deposit it into the Euro account

By buying the Euros up front, today's exchange rate is locked in, and future Euro fluctuations do not affect the cost of the contract.

There are several problems with this approach:

1. It is unlikely you will get a good exchange rate or competitive interest rate at the bank;
2. You need to pay roughly USD$750,000 or more to buy the Euros up front, using scarce cash resources. You may not have these USD funds or an available credit line.
3. If you are using a credit line to fund the Euro bank account, the USD credit line will likely have a higher rate of interest.

Solution B: Currency Forward Contract

At a major bank, ask for a currency forward contract. A currency forward contract is a negotiated agreement between two parties to exchange specific amounts of currency at a set rate on a particular day. The forward rate is priced based on the current exchange rate, the interest differential for the contract time, a cost to cover potential negative changes to the interest risk differential, and a flexible built-in commission for the forward contract provider.

Currency forward contracts tend not to be very flexible, so there are several disadvantages:

1. Often, the forward rate includes an uncompetitive exchange rate or high built-in commission, making this solution quite costly;
2. You would require many forward contracts for more complicated scenarios (such as monthly payments)
3. Since a forward contract is between two parties, there is no secondary market for the purchase and sale of these contracts, making them rather inflexible or expensive to extend or terminate early.

Solution C: Futures Contract

Buy a futures contract on a formal exchange from an authorized dealer. Futures are similar to forward transactions, in that the cost is based on the current exchange rate, the interest differential for the contract time, an amount to cover potential negative changes to the interest risk differential, and a formal commission.

The major advantage of futures contracts over forward contracts is the existence of a liquid secondary market on the formal exchange so they can be sold at any time on the open market and do not have to be held until their maturity date.  Futures contracts can be traded on organized exchanges such as the Chicago Mercantile Exchange (CME) or London International Financial Futures Exchange (LIFFE). These exchanges dictate contract specifications, such as expiration times (third Wednesday of March, June, September and December), face amount, and margin requirements.

Disadvantages of futures contracts for the purpose of hedging include:

1. Futures contracts involve not just a spread, but also a commission;
2. Face value of futures contract are fixed. For example, British pound futures are sold in GBP 62,500 and Euros are generally sold in lots of EUR 125,000, making it difficult to make up the exact value of EUR 500,000;
3. A margin deposit must be posted and maintained daily;
4. Limited expiration times;
5. It is unlikely you will get a good exchange rate or competitive interest rate on your margin account;
6. Futures contracts are typically speculative, so taking delivery of the money at the end of the term is not expected and may cost commission.

Solution D: Currency Options

Buy a currency option at a bank. A currency option gives the holder the right, but not the obligation, to sell or buy a face amount of currency at a set price, on or before a given date. A currency option has a strike price, being the amount for which the currency can be bought or sold for, and an expiration date. US options can be exercised any time up to and including the expiration date, whereas European options can only be exercised on the expiration date. There are two types of options. Call options give the holder the right to buy a given amount of a currency at the strike price. Put options, on the other hand, give the holder the right to sell a given amount of currency at the strike price.

Options are one-sided contracts (options, but not obligations) that are priced based on a number of variables (exchange rates, interest differentials, duration of contract, historical exchange rate volatility, and a built-in commission for the provider). They are a method of speculating on future currency movements, and you pay a price for that right to speculate.

Like futures, the major advantage of options over forward contracts is the existence of a liquid secondary market. As a result, options can be sold at any time on the open market and do not have held until their expiration date.

The disadvantages are also similar:

1. Options traded on formal exchanges must be purchased in fixed face values and lot sizes. Some banks offer their own options with any notional amount, but these options may cost you more as you will not be purchasing the option in an open market. 
2. The options have to be purchased. There is a cost involved, and premiums to pay.
3. You will bear the risk and potential cost associated with the difference between the amount to hedge and the fixed option amounts.
4. They have expiry dates.

Solution E: Carry spot trading using OANDA FXTrade

Currency hedging through online retail spot trading is surprisingly straightforward, given the new generation of currency trading platforms such as OANDA's FXTrade.  All transactions can be completed over the Internet using a standard Web browser, at any time, 365 days a year. No bank visits are required (until it comes time to arrange your actual monetary transaction).

In the above scenario, you would open a USD-based FXTrade account, deposit margin capital of, say, 10% or $75,000, and buy (long) 500,000 EUR/USD today. (That is, you would open a trade whereby you buy 500,000 EUR and sell 750,000 USD.) You would close this trade six months later when the payment is due and withdraw the margin capital plus/minus profit/loss and the interest rate differential.

If the Euro went up over 6 months: If the new EUR/USD rate is 1.60 after 6 months, your long position on FXTrade will be worth approximately:

1.6*500,000 - 1.5*500,000 = 800,000 USD - 750,000 USD = 50,000 USD

So the hedge would be worth 50,000 USD more when you close it (plus or minus the interest rate differential). The original EUR 500,000 would now cost 800,000 USD (500,000 x 1.6); however, you have made 50,000 USD on your hedge. Your hedging strategy has ensured your total cash cost stays at 750,000 USD (800,000 - 50,000).

 If the Euro went down over 6 months: If the new EUR/USD rate is 1.40 after 6 months, your long position on FXTrade would cost approximately:

1.4*500,000 - 1.5*500,000 = 700,000 - 750,000 = - 50,000 USD

So the hedge would cost 50,000 USD when you close it (plus or minus the interest differential). The original EUR 500,000 would cost 700,000 USD (500,000 x 1.4, a 50,000 USD saving). Your hedging strategy has ensured your total cash cost stays at 750,000 USD (700,000 + 50,000).

What are the costs?

The cost of this type of hedging is the cost of the spread, which is typically 0.9 pips, or around $22.50 for the example scenario, and the interest rate differential depending on the two currencies you're trading. (You would still need to pay the unavoidable bank fees and bank exchange rates when you make the actual payment, but only at the time the payment is due.)

The disadvantage of this approach is that proper margin must be maintained at all times to avoid margin calls. To reduce this possibility, you may wish to deposit more margin in your FXTrade account. (OANDA pays competitive interest on all margin account balances.)

Comparison Summary

Costs

	A Bank Account	B Forward Contract	C Future Contract	D Currency Option	E Carry Spot
Overall Costs
Special Charges
Large Spreads
Large interest differential
Interest risk premium
Commissions
Volatility charge
Spreads: Bank accounts typically charge spreads 2% or 3% above interbank spreads. Forward contracts, future contracts and currency options charge close to interbank spreads, but do have the following built-in or explicit commissions and other special charges: Interest differential: All hedging methods charge an interest differential on the currencies, either built into the rate offered or as a separate amount charged. Bank accounts typically charge interest 2% to 3% above interbank rates for funds borrowed to purchase the foreign currency (and pay much lower rates for funds deposited). Interest risk premium: Interest risk premium is a variable amount charged by the issuing party for potential changes in interest rates. Commissions: Forward contract and option contract suppliers build commissions into their products based upon how much they can charge the buyer. The commission is built into the forward rate or included in the amount paid upfront for an option (it is also called the premium). Volatility charge: Options are one-sided contracts which cost an upfront premium to purchase. Options offer the right, but not the obligation, to engage in a future transaction. An estimate of the future volatility of the foreign currency over the life of the option is built into the option pricing. While an individual option may incur a large payout, other options will expire without being exercised.

Features

	A Bank Account	B Forward Contract	C Future Contract	D Currency Option	E Carry Spot
Early Exit?
Extend beyond expiry date?
Hedge exact amount?
Change hedge amount?
Early exit: Forward contracts require break costs if you exit early. You risk market uncertainty by selling a future contract, or selling/exercising a currency option. Extensions beyond expiry date: Bank accounts and currency spot have no expiry dates. The other products will require you to enter into new hedging contracts or risk currency fluctuations between the expiry date and when the foreign exposure is settled. Hedge exact amount: Contracts and options only offer fixed lot sizes. Currency spot and bank accounts allow you to hedge to the nearest unit. Forward contracts in theory may be structured to exact amounts, although often the amounts are not precise. Change Amount: You can change the hedging amount by any amount for bank accounts or currency spot. For contracts and options, you can only add or sell/exercise a fixed lot size.

Credit Requirements

	A Bank Account	B Forward Contract	C Future Contract	D Currency Option	E Carry Spot
Upfront Cash Requirements
All hedging options require either upfront cash, or require necessary credit arrangements with the counterparty. A bank account requires the largest amount of upfront cash (the full hedge amount). Currency options must be purchased upfront with cash. Forwards will only be offered as part of your overall credit arrangement with the supplier, and any resulting forward contracts will reduce your available credit lines. Future contracts and currency spot hedging will require adequate margin amounts to cover the necessary credit requirements.

Advantages Unique to OANDA FXTrade

To summarize, some of the advantages unique to using OANDA FXTrade for hedging include:

• FXTrade allows the hedger to execute any size of transaction. Unlike futures or options which are sold in set block sizes, FXTrade permits the hedger to execute any size of transaction. A company can hedge exactly the amount required—the perfect hedge. Down to $1.
  
  
• There are no commissions or premiums charged by OANDA for executing transactions on FXTrade. The only amount you pay is the low spread, plus the interest rate differential. OANDA's spreads are some of the tightest in the currency business, and it applies fair interest rates.
  
  
• Unlike currency forwards, FXTrade positions can be settled at any time, 24 hours a day, 365 days a year. The hedger never needs to hold on to a disadvantageous position.
  
  
• FXTrade is flexible. If you cancel, partially cancel, or increase the size of your order, you can easily increase or decrease your FXTrade hedge position.