Currency Hedging For Importing Businesses
Many businesses of all sizes often Import items from foreign countries and as such are required to deal with many different currencies on a regular basis. However, when holding currencies it is important that they too hedge their currency exposure. Hedging may sound complicated but all it refers to is methods of trying to reduce your exposure to the various risks outlined in the other articles in this section. As the currency market is as volatile and unpredictable as ever, many companies and individuals are looking to hedge their currency portfolio, corporation or foreign assets from the risk of fluctuations.
The type of currency hedging strategy used, will depend on the expectations and needs of the importer. A greater desire for flexibility may propel the importer to opt for swaps and options. In case of forwards and futures, familiarity with the counter party to the contract would determine the strategy.
One option for an importer is to enter into a forward contract to buy a fixed amount of a currency for a given amount of GBP, USD etc. A currency forward contract is an agreement to purchase or sell the currency at a pre-agreed price at a set date in future, regardless of the price of the asset in the spot market.
Assets are traded at the currently prevailing prices in the spot market. The two parties to a forward contract are the long and the short. This arrangement helps eliminate uncertainty, in the amount of payment that has to be made for imports, on account of fluctuating foreign currency.
The importer can take a long position in the forward contract and thus
Similar to these contracts, a futures contract was designed in order to overcome the disadvantages of a forward contract. One of the disadvantages, of a forward contract, is that the
contract is not standardised. Essentially, the entire payment has to be made or received, in one go, at some point of time in future so the
chances of default are high. Thus a futures contract that allows the importer to pay a set price for the Euros that would be purchased at
a later date, can help him hedge foreign exchange risks.
The final option for businesses looking to import is currency swaps. The importer can enter into a currency swap with a European trader who needs Dollars. In other words, the importer exchanges a fixed amount of Dollars for Euros so that he has the necessary foreign currency to make payments in future. The importer is expected to pay interest, at a fixed or floating rate, on the Euros borrowed while the European trader pays interest on the Dollars to the importer.
On the maturity date of the swap, the currencies are exchanged so that the parties have the currency they started out with. These swaps are
negotiable for at least 10 years, thus making them a highly flexible strategy for currency hedging by importers.