Corporate treasurers are often challenged to create and obtain alignment on FX strategies and policies, and as part of that often need to ensure their board and senior leadership are comfortable with their approach to FX hedging.
But treasurers often recount facing resistance to their plans based on a perception that their hedging efforts would be "speculation." As a result, they are unable to get approval to incorporate their hedging strategies as part of the company's FX strategy and risk policy.
But this takes a significant tool off the table for some treasurers. Hedging is a strategic method used by financial teams across all sectors to mitigate risk and potential losses — the complete opposite of what speculation sets out to do.
Ironically, businesses that do not consider the role hedging could play as part of their strategy put themselves at a disadvantage, with increased costs or reduced opportunities and flexibility to reduce risk. This is particularly true for FX exposed companies who buy and sell across global currencies.
For this reason, it is important that company leadership understand what FX hedging is, and its role as a tool for risk reduction when used in alignment with appropriate boundaries. Then it can be assessed as a viable component of their FX risk and governance policies.
In this article, we will explore the key differences between hedging and speculation, and show how FX hedging can be an important part of a company's FX strategy.
The Difference Between Hedging and Speculation
The main difference between hedging and speculation is the purpose behind the approach.
Hedging is a risk management strategy that aims to reduce or eliminate the potential for losses by offsetting one investment with another.
Treasurers can use hedging to protect businesses against unexpected price changes, currency fluctuations, or interest rate movements. It’s about shielding existing assets, rather than finding a way to make profit or find an ‘upside’ in the market.
For example, let's say a US company needs to buy materials from a supplier in Europe six months from now, but the exchange rate between US Dollars and Euros could change, which would affect the cost of the materials.
To protect against this risk, the company enters into a contract with a bank that guarantees they will be able to buy Euros at a fixed exchange rate and receive the funds in six months, no matter how the exchange rate changes. This is called a "forward contract."
In this context, the forward contract is a “hedge.” The business is purchasing a financial instrument that protects them against negative change and allows them to operate with more certainty. A forward contract may result in a company profiting from a change in the market, but that is not the primary intention when used as part of a risk mitigation strategy.
For more information on forward contracts, check out our Introduction to FX forwards.
Speculation is a strategy that involves taking on risk with the explicit aim of making a profit from price movements.
This could involve buying an asset with the expectation that its value will increase or making a bet on the outcome of a market event. Speculators often have no direct interest in the underlying asset and seek to profit from changes in its price.
For example, a US company might think that the Euro may strengthen against US dollars in six months. To make a profit from this, they buy Euros now with US dollars, hoping to sell them back for more US dollars when the Euro's value has gone up. They buy 1,000,000 Euros for $1,100,000 USD now, and in six months, the Euro's value has gone up, so they sell the 1,000,000 Euros for $1,200,000 USD, making a $100,000 USD profit.
This approach is risky and often results in loss rather than profit. For example, the UK’s Financial Conduct Authority recently reported that 80% of retail FX traders lose money with speculation.¹
Why FX hedging is invaluable to Treasury teams
The ability to use FX hedges within boundaries appropriate to the business can have significant positive implications for a company.
- Risk Management: By locking in terms, hedging allows companies to protect themselves from potential financial losses due to market volatility.
- Business Strategy and Stability: Hedging allows companies to set strategic plans based on a degree of certainty over future liquidity and financial position. By executing FX hedges, businesses can be assured they will have the right amount of cash in the right currencies when they need it.
- Flexibility and cost control: The inclusion of FX hedges as part of a risk policy allows treasurers to control the level and pace of mitigating risk. Depending on when FX exposure is expected to occur, they can choose how much or what % of that exposure to hedge and when. This also allows treasurers to identify the best timings for hedges where trade costs would be lower.
To achieve these benefits, it is essential to have a clear written FX policy that sets out guidelines agreed by the company's board and leadership team. These policies can outline guardrails, such as how far in the future a treasury team can hedge, the % of risk that must be covered and when, the type of hedge instruments that are permitted, and whether certain currencies should have different rules.
It is also important to have a systematic process of identifying and evidencing exposure, and tracking how much of it is covered and by what instruments, and monitoring to ensure that FX hedges stay in alignment with day-to-day changes in the business that impact exposure amounts.
In addition, treasury teams that can show they are achieving the agreed objectives and risk guidelines are more likely to gain support for their FX strategies.
Demonstrate the Value of FX Hedging with Just
Fortunately, there are straight-forward ways for treasurers to demonstrate the successful application of FX hedging strategies. Treasurers and their teams can use data analysis, or FX analytics, and automated platforms to make it easy to run the systemic processes to control exposure with FX hedges. They can also use these same tools to show success and alignment with the company's FX policy.
The right FX analytics tools make it easy for Treasurers and treasury teams to:
- Track FX exposures for future periods (either based on a company's cash flow or business projections, or effective predictions based on a company's historical activities)
- Understand how future volatility and movements in exchange rates might create additional risk based on their exposed currencies
- Show how hedges are booked based on a systemic and data-driven approach to offset those exposures
- Monitor that FX hedges remain in alignment as day-to-day changes in the business result in changes to FX exposure and risk
- Verify and demonstrate how hedging is in compliance with the risk and governance boundaries agreed by the leadership team
The right tool can also reduce human error and make it easier to achieve the above more quickly through automation.
At Just, we’ve built and continue to build solutions to deliver these objectives in keeping with our mission to empower treasury teams to access liquidity on fair terms. With Just treasurers can use data and powerful features to set, run and monitor the right FX strategy for their organisation so that unnecessary FX costs and FX risks are eliminated as much as possible.
Want to see how much you could improve your FX hedging strategy? Book a demo to see FX Hedge Check in action.