Foreign Exchange (FX) hedging can be a useful tool when seeking to mitigate foreign exchange rate risk. Notably, for businesses that have a predictable cash flow from a foreign country in a foreign currency, rolling hedges may be useful in protecting that business’s cash flow from swings in foreign exchange rates. While businesses can use FX hedging to insulate from foreign currency conversion loss due to an unexpected shift in a foreign exchange rate, FX hedging can also prevent that business from realizing a gain in foreign currency conversion should the foreign exchange rate experience a favorable shift. While an unexpected bump in cash flow from a favorable foreign exchange rate shift is a welcome surprise to most (if not all) businesses, some businesses are willing to forgo this potential upside or gain if it means guaranteeing, through FX hedging, that they will not experience an unexpected shortfall in their cash flow due to a detrimental foreign exchange rate shift.1
What is a Rolling Hedge in Regards to FX Hedging?
A rolling hedge is a strategy through which businesses maintain a number of FX hedges through futures and options, with varying expiration dates, in order to have a certain percentage (or all) of their expected cash flow from foreign markets hedged against foreign exchange rate fluctuations. It can help to visualize a rolling hedge as a conveyer belt of hedge positions: as one executed FX hedge position (through the use of futures contracts, or put or call options, or a combination) expires, there is already another FX hedge position right behind it to take its place, and another one behind that one, and so on and so on.2 These FX hedge positions do not have to be identical: they can be for varying amounts, varying strike prices, etc. Thus, the rolling FX hedge position can be tailored to a business’s cash flow and foreign exchange needs.
Businesses can utilize a rolling hedge to manage their global cash flows, as well as an FX hedging tool, on a continuous basis. Instead of simply reviewing their foreign exchange exposure and setting up an FX hedge once a year, businesses can dynamically manage their FX hedging on a quarterly, monthly, or even weekly basis. One important side benefit of utilizing a rolling hedge is that it forces a business to earnestly look at its international cash flows, as well as its foreign exchange exposure, on a regular basis.3 It is important to note that unlike most futures contracts for commodities, such as wheat, metals, pork, oil, etc., which generally are not closed out for delivery but are instead rolled over into other future contracts or closed out for cash, foreign currency futures contracts are, quite often, exercised for delivery upon expiration,4 meaning the fund is bought out before a new contract is purchased.
What is a Short Hedge in Regards to FX Hedging?
A short hedge, in regards to FX hedging, is a strategy that seeks to mitigate an FX risk (a currency risk) which has already been taken. The reason it is referred to as a short hedge is because a security (in this case, a foreign currency derivative contract, such as a forward contract or a call or put option), is shorted. By shorting this derivative contract, the trader (or business) is able to hedge (protect or mitigate themselves from risk of loss) against their long investment in the underlying asset (the foreign currency).5
If the short hedge is executed properly, then losses resulting from the long position in the underlying foreign currency will be offset from the gains in the short derivative position. Conversely, if the foreign currency gains in value, which would result in a gain to the trader or business, those expected gains will be offset by the losses resulting from the short derivative position.
For example, let us say that today, Euros are trading at US$1.00 per Euro. The currency trader expects to receive a payment in the form of EUR1,000 on June 1st (meaning, the trader is now “long” in Euros, since Euros will be received). Worried that the value of the Euro may drop between now and June 1st, the trader enters into a short hedge, by promising to sell 1,000 Euros via a forward contract, expiring on June 1st, at US$0.90 per Euro. If the price of the Euro on June 1st is US$1.10, the currency trader will still net US$1.00 per Euro, because while EUR1,000 is being received as payment, worth US$1.10 per Euro (so, US$1,100) the trader is short because of the forward contract, promising to sell to the other party in the forward contract EUR1,000, at a price of US$0.90 (so, US$900). By selling those 1,000 Euros below market value, the trader is incurring a loss of US$200 (because those 1,000 Euros are now worth US$1,100 on the open market). But, the currency trader received an extra US$100 by receiving the payment of 1,000 Euros on June 1st, because those 1,000 Euros are worth US$1,100. The net effect is a wash, and the original payment of 1,000 Euros is still effectively worth US$1,000. In this manner, the trader, or business, can execute an FX hedge against currency fluctuations, to ensure that the expected cash flow of 1,000 Euros will equal the expected currency exchange of US$1,000, and not suddenly more or less.
While giving up the potential gain, the business guarantees no potential loss, so that cash flow and budgeting can be accurately forecast, without fear of an unexpected cash flow shortfall which could hinder paying suppliers, lenders, employees, or other obligations.6
FX hedging is an important tool in a business, and a CFO’s tool box when seeking to mitigate risk and assure a steady and predictable cash flow position. It is important to understand the benefits and risks associated with derivatives and how to properly use them to their greatest benefit.