What does “hedging” mean in foreign exchange?
Hedging is a way to protect profit margins from potential losses due to fluctuations of the foreign currency market.
Businesses with foreign currency exposure (i.e. those making foreign payments) typically set an internal cost of goods/services based on the exchange rate at that time. When payables come due however, the market exchange rate can be drastically different from the previously set internal price.
This market-related pricing difference can leach away the business’ profit, or turn a good deal into a losing one.
Paymentearth offers hedging products to protect your bottom line, and keep your profit where it belongs- in your company!
What is a Forward Contract in foreign exchange?
Within the world of foreign exchange, Forward Contracts serve as client-provider agreements to “lock in” a foreign currency amount, at a specific rate of exchange (forward contract rate), for an agreed-upon window of time.
How far out do people usually buy Forward Contracts?
While there’s no standard formula for utilizing Forward Contracts, most are booked from as little as two weeks from the current date, to as far forward as 12 months.
What does a Forward Contract cost?
Forward Contacts, despite somewhat ominous sounding terminology, are relatively simple:
Cost = Foreign amount x Forward Rate of Exchange
In essence, the only difference between a Forward Contract, and a Spot payment, is that a Forward Contracts must account for the delay in delivery. This is done by adding/subtracting Forward Points to the exchange rate- these points are based on the differential between the two currencies’ interest rates.
Example: 3 month EUR Forward Contract
100K EUR x FWD RATE (1.1206) =$111,890
FWD Rate = 1.1120 + 86 Forward points (3 months)
A 5% deposit is required when the trade is booked to mitigate Paymentearth’s risk in the event of market movement against the value of the contract.
What are forward points?
Forward points are a premium, or discount charged by EVERY liquidity bank to EVERY foreign currency exchange provider. They are based on the difference in interest rates set by the central banks of each currency (Federal Reserve, European Central Bank, Bank of England, etc). Forward point curves are available via a wide variety of nationally published financial news sources.
What are the different types of Forward Contracts?
Paymentearth offers Forward Contracts in two flavors: Fixed Date and Window.
Fixed Date Forwards– buy/sell a specific amount, for a specific future date.
Window Forward– buy/sell a specific amount, for a date range (1 month, 3 months, 5 months etc) Clients can access (draw down) the funds of a Window Forward any time within their specified range.
How can I hedge currency risk with Forward Contracts?
For the following forward contract example, let’s say your company imports machinery from Italy, and you pay for a product in Euros.
Your supplier has recently shipped an order, but your invoice will not come due until the end of the quarter- nearly 3 months from now.
Simultaneously, the Federal Reserve announced a hike in interest rates, and the USD has gained 1% against the EUR!
By booking a Forward Contract now, savvy customers can lock in the favorable exchange rate for the Euro amount due at the end of the quarter, and at the same time, preserve the profit margin already factored into the sale.
What happens if the market improves after I buy the contract?
The purpose of a Forward Contract is to secure profit margins, removing clients’ exposure and potential losses as a result of market movements; Forward Contracts are not intended for speculative purposes.
If the market rate is better than the Forward Rate, at the time a contract is due, the contract remains valid, and the currency belongs to the client. Cashflow permitting, the client can always opt to buy additional currency at the current market rate, and leave the Forward Contract funds in holding, for later use.
What are Standing Orders?
Standing orders are another way of hedging foreign exchange risk by allowing you to set a target price for a specific amount. Once placed, our automated process tracks your order relative to the market rate. When/if the market hits the level you want, the currency is purchased and placed into holding, for later disbursement.
Example: Client places Standing Order of 100K EUR @ target rate of 1.1200
The Market rate fluctuates for 2 weeks between 1.1225-1.1400, before finally falling below 1.1200. When the market rate hits the target rate, the 100K EUR are automatically purchased on the client’s behalf.
Why would I place a Standing order?
Standing Orders are especially useful in a highly volatile market, when the dollar may make wide swings over a short amount of time.
Standing Orders allow clients to secure rates that might otherwise be missed during non-trading hours.
How is a standing order different from a forward contract?
A Standing Order is essentially a spot deal on autopilot. Currency is bought and paid for when the Order hits the target rate, whereas a Forward Contract is a purchase that secures the current exchange rate, but with settlement based on the terms of the Forward (1-3-6 month etc).
Forecasting
Whether bidding upcoming jobs or pricing goods and services, our expertise can guide you on market movements and market expectations, helping to secure profits and greatly reduce risk. Subscribe to our daily FX market report (free), where prospective and current clients keep up to date on the latest Forex market news. This daily report is generated by aggregating information from major news sources and industry analysts, compiled into an easy-to-read digest each morning. For more tailored market updates, simply connect with any of Paymentearth’s expert account representatives.
