5 Basic Principles to Hedging Correctly

5 Basic Principles to Hedging Correctly
Learn the basics of protecting yourself from price changes in foreign currencies, interest rates and commodities.

Whether hedging foreign exchange, commodity prices or interest rates, there are a handful of basic principles that should be followed to ensure you get the results you seek.  In a nutshell, hedging is the process of offsetting the risk of price movements in the spot market by locking in a future price. While the term “hedge” may sound intimidating, all it represents is defending against the risk of future price changes. 

We will define below the five core principles that apply whenever you enter a hedge, regardless of whether you do so using okoora’s ABCM™ platform or through other means. 

Hedging basics 

  1. Pinpoint the risk 

The first step you must take even before you purchase a financial instrument is to identify the risk that needs to be protected against. In the foreign exchange market, the primary risk is changing foreign exchange rates. The risk of an unfavorable change in an exchange rate can be managed with a forward or an option. 

  1. Fix the hedge ratio 

 The hedge ratio is the proportion of the underlying asset that is protected by the financial instrument. The correct ratio for the business should be determined based on the level of risk that the business owner is willing to undertake (i.e. risk averseness), the size of their profit margins, level of competition in the industry in question and potentially other factors as well. For example, if an exporter sells $1 million worth a month product to the U.S. and their expenses are primarily incurred in a local currency that is not USD, they may wish to insure 50% of their risk using a forward contract, or $500,000 per month. 

In general, when defending against risk, the closer the target date the higher the hedging ratio should be. This is because the greater certainty there is regarding the sum to be defended the greater the amount you can hedge with confidence. 

  1. Select the hedging instrument 

After the risk to your business has been pinpointed and the hedge ratio has been selected, you may then determine the financial instrument that is appropriate to protect against the risk. For example, an exporter who is concerned that their local currency is appreciating against the currency in their target market may use a forward or a call option to reduce or eliminate risk. 

  1. Keep tabs on your hedge 

Once you have entered into a hedge transaction it is important to keep track of it to ensure that it is effectively managing the risk that you are defending against. This requires monitoring the performance of the financial instrument and the underlying asset to ensure that the performance of the two are counterbalancing each other. A good hedge should always offset the volatility of the related asset. 

  1. Adjust the hedge 

As market conditions change, you may need to make changes to your hedge to ensure it continues to effectively defend against the risk you pinpointed. For example, if the local currency continues to appreciate against the U.S. dollar, the exporter in our previous example may need to adjust their hedge ratio to ensure that they are still sufficiently protected from losses. 

Advantages and disadvantages of hedging 

We already described above the primary benefit of hedging: reducing exposure to the impact of changes in prices for the protected asset. However, there are downsides to hedging, namely the cost of the financial instrument and the missed opportunity to profit from favorable changes in prices. In the case of a forward, where you commit to actually buying a currency at a specific rate on a specific date, the possibility for lost profits can be significant. In the case of an option, where you are buying the right to purchase a currency at a specific price on a specific date, the potential impact on profits is lessened by the fact that you do not need to exercise the option. However, when buying an option you pay a premium for this right and this cost remains. 

This is why you should closely consider your risk tolerance and potential costs before engaging in hedging. Nevertheless, most importers and exporters would benefit from a hedging policy. It’s just a matter of knowing the parameters that will inform your strategy, whether using an intelligent system to design your hedge or relying on an individual advisor. 

To learn more about okoora’s ABCM platform helps automate and intelligently manage your cross-border currency risks, click on the link.