Understanding Currency Risk

What is Currency Risk?

Currency risk refers to the potential for fluctuations in the value of one currency relative to another. Businesses and investors with foreign currency exposure—whether through operations, transactions, assets, or liabilities—face the possibility that changes in exchange rates can impact the value of their investments or business activities. Currency risk manifests in different forms:

1. Transaction Risk
   This arises when a company has future cash flows in foreign currencies, such as receivables or payables. Fluctuations in exchange rates between the transaction date and settlement date can alter the final amount received or paid.
2. Translation Risk
   Multinational companies with foreign subsidiaries face translation risk. When consolidating financial statements, changes in exchange rates can impact the reported financial position and results of these subsidiaries.
3. Economic Risk
   This risk relates to how exchange rate movements can affect a firm’s market value, competitiveness, and long-term future cash flows. Economic risk is often tied to broader market and operational factors, such as pricing, cost structures, and global competition.

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Why Hedge Against Currency Risk?

Hedging against currency risk provides several benefits for businesses and investors:

• Stable Cash Flows: Hedging allows companies to lock in exchange rates, stabilizing cash flows and reducing uncertainty.
• Cost Control: By managing currency risk, businesses can better control costs related to international transactions and protect profit margins.
• Competitive Advantage: Effective currency risk management can enable businesses to offer more stable prices, providing a competitive edge over rivals who may not be as protected.
• Risk Control: Hedging protects investments from devaluation caused by unfavorable changes in exchange rates.

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Common Hedging Strategies

1. Forward Contracts What Are Forward Contracts? A forward contract is a customised agreement between two parties to exchange a specified amount of one currency for another at a predetermined rate on a future date. Forward contracts allow businesses to lock in exchange rates, providing certainty over future foreign exchange cash flows. How Forward Contracts Work
   • Customisable: Businesses can tailor forward contracts to meet their specific needs, such as the amount of currency and the settlement date.No Upfront Costs: Forward contracts generally do not require an initial premium, making them cost-effective tools for hedging.
   Example
   A U.S. importer needs to pay €1 million to a European supplier in three months. With the current exchange rate at 1 USD = 0.85 EUR, the importer is concerned the euro may appreciate. The importer enters into a forward contract to buy €1 million at 1 USD = 0.85 EUR in three months. Regardless of the spot rate at that time, the importer will exchange USD for EUR at the agreed rate.

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2. Futures Contracts What Are Futures Contracts?
   Futures contracts are standardised agreements to buy or sell a specified amount of currency at a predetermined price on a set future date. Unlike forwards, futures contracts are traded on exchanges, which guarantees liquidity and standardisation. How Futures Contracts Work
   • Standardisation: Futures contracts are traded on exchanges, offering standardised terms and higher liquidity.Margin Requirements: Participants must deposit a percentage of the contract’s value as collateral (initial margin) and maintain a margin throughout the trade (maintenance margin).
   Example
   A U.S.-based company expects to receive €500,000 in six months. To protect against depreciation of the euro, the company sells €500,000 worth of futures contracts at the current futures price. If the euro depreciates, the company will make gains on the futures contracts, offsetting the losses in euro-denominated receivables.

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3. Options What Are Options?
   Currency options give the holder the right (but not the obligation) to exchange one currency for another at a predetermined rate on or before a specified future date. There are two types:
   • Call options (the right to buy)
   • Put options (the right to sell)
   How Options Work
   • Flexibility: Options offer flexibility as the holder is not obligated to exercise the contract.
   • Premium: Purchasing an option requires paying an upfront premium, which is the cost of securing the hedge.
   Example
   A UK-based exporter expects to receive $1 million in three months. Concerned about a potential depreciation of the USD, the exporter buys a put option to sell $1 million at an exchange rate of 1 GBP = 1.30 USD. If the spot rate falls below this level, the exporter can exercise the option and sell USD at the more favorable rate.

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4. Currency Swaps What Are Currency Swaps?
   Currency swaps involve the exchange of principal and interest payments in one currency for principal and interest payments in another currency. This strategy is useful for managing long-term currency exposure, especially when dealing with debt. How Currency Swaps Work
   • Payment Exchange: Two parties agree to exchange principal amounts and periodic interest payments in different currencies.
   • Flexibility: Currency swaps can be customized to meet specific needs, such as debt repayment or investment returns.
   Example
   A Japanese company with USD-denominated debt enters into a currency swap with a U.S. company that has JPY-denominated debt. They agree to swap principal and interest payments, thus converting their debts into their respective domestic currencies and mitigating currency risk.

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5. Natural Hedging What Is Natural Hedging?
   Natural hedging involves structuring business operations to offset currency risks without using financial instruments. This can be done by matching inflows and outflows in the same currency or by diversifying operations to multiple countries with different currencies. How Natural Hedging Works
   • Matching Inflows and Outflows: Businesses can reduce currency risk by aligning their revenues and expenses in the same currency.Diversification: By spreading operations and investments across multiple currencies, a business can reduce overall exposure.
   Example
   A multinational company operating in both the U.S. and Europe can use euro-denominated revenues to cover euro-denominated expenses, minimising the need for currency conversions and reducing exposure to exchange rate fluctuations.

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Implementation of Hedging Strategy

1. Step 1: Measuring Your Exposure
   Identifying all cash flows, assets, and liabilities exposed to currency risk is the first step in developing a hedging strategy. Key exposures include:
   • Transaction Exposure: Future cash flows in foreign currencies (e.g., receivables and payables).
   • Translation Exposure: The impact of exchange rate changes on financial statements.
   • Economic Exposure: How currency movements affect a company’s competitive position and market value over the long term.
2. Step 2: Set Objectives
   Clear hedging objectives should align with broader financial goals and risk tolerance. Typical objectives include:
   • Stabilizing Cash Flows: Reduce volatility for more predictable cash flows.
   • Profit Margin Protection: Protect margins from fluctuations in exchange rates.
   • Competitive Advantage: Ensure stable pricing for customers and suppliers.
3. Step 3: Choosing Hedging Instruments
   Select the appropriate hedging instruments based on exposure and objectives:
   • Forward Contracts: For certainty in hedging specific future transactions.
   • Futures Contracts: For standardised, exchange-traded hedging with liquidity.
   • Options: For flexibility and protection with the cost of a premium.
   • Currency Swaps: For long-term exposures and debt management.
   • Natural Hedging: For reducing exposure through business structure.
4. Step 4: Implement the Hedge
   Execute the hedging strategy by negotiating terms with financial institutions, and executing transactions. Ensure all necessary documentation is completed.
5. Step 5: Monitor and Adjust
   Currency markets are dynamic, and exposure may change over time. Regularly review and adjust the hedging strategy to align with evolving business conditions.
   • Review Exposure: Assess any changes in exposure due to business or market developments.
   • Check Effectiveness: Evaluate how well the hedge is achieving its objectives.
   • Adjust Hedging Positions: Modify positions as needed to maintain effective coverage.

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Case Study: Effective Hedging in Action

Background
TechSolutions Inc., a U.S.-based manufacturer, outsources components from Japan and sells finished products in Europe. The company faces significant currency risk due to its dealings in JPY and EUR.

Exposure Identification

• Transaction Exposure: Payments to Japanese suppliers in JPY and receivables from European customers in EUR.
• Translation Exposure: Consolidation of financial statements from European and Japanese subsidiaries into USD.
• Economic Exposure: Currency fluctuations impact TechSolutions’ competitiveness in Europe and Japan.

Setting Objectives

• Stabilize Cash Flows: Minimize cash flow variability due to currency risk.
• Protect Profit Margins: Avoid profit erosion caused by unfavorable exchange rate movements.
• Maintain Competitive Pricing: Offer price stability to customers and suppliers.

Hedging Instrument Selection

• Forward Contracts: Lock in exchange rates for future payables in JPY and receivables in EUR.
• Options: Use options to hedge against unfavorable movements while allowing flexibility to benefit from favorable rate changes.
• Natural Hedging: Match revenues and expenses in the same currencies to reduce currency risk.

Executing the Hedge

• Forward Contracts: TechSolutions negotiates forward contracts to buy JPY and

sell EUR at agreed rates for the next 12 months.

• Options: The company purchases put options for EUR/USD and call options for USD/JPY.
• Natural Hedging: The company synchronises its invoicing and procurement operations to reduce currency exposure.

Monitoring and Rebalancing

• Quarterly Review: TechSolutions reviews hedging positions quarterly, making adjustments as needed.
• Performance Evaluation: The company assesses the effectiveness of its hedging strategy based on actual cash flows and profit margins.

Results TechSolutions achieves:

• Stable Cash Flows: Reduced volatility enhances financial planning and budgeting.
• Protected Margins: Profit margins are preserved despite fluctuations in JPY and EUR exchange rates.
• Competitive Advantage: Stable prices for customers in Europe and suppliers in Japan strengthen TechSolutions’ competitive position.

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How Cambridge Currencies Can Help to Hedge Against Currency Risk

Why Hedge Currency Risk?
Hedging currency risk is vital to protect profit margins, stabilize cash flows, and maintain competitive pricing. Cambridge Currencies offers expert hedging solutions tailored to your business’s needs.

Cambridge Currencies: Your Hedging Partner
Cambridge Currencies provides a range of hedging tools to meet the diverse needs of businesses and individuals:

• Forward Contracts: Tailored to lock in exchange rates for future transactions.
• Currency Options: Provide flexibility and protection from currency fluctuations.
• Currency Swaps: Manage long-term currency exposure and debt obligations.
• Market Insight and Analysis: Stay informed with real-time data and expert advice.
• Natural Hedging Strategies: Align business operations to offset currency risks organically.

Contact Cambridge Currencies today to secure your financial future and manage currency risk effectively.