Managing Currency Risk in a Global Business
When you manage business operations across multiple countries, currency fluctuations can either work for you or against you.
I know this firsthand.
When I worked for Evalueserve in Chile, I was responsible for managing business operations across North and South America while coordinating with our parent company in Switzerland and headquarters in India. This meant dealing with multiple currencies, and when handling financials across continents, exchange rate swings can significantly impact the bottom line.
As part of my job, I was asked to put forward contracts in place to hedge against foreign exchange risk. Without a strategy, currency fluctuations could have eroded profits overnight.
So, how do businesses like Evalueserve—and countless others—protect themselves from foreign exchange risk?
That is where hedging comes in.
This post will break down two of the most widely used FX hedging strategies:
- Forward contracts (locking in an exchange rate for future transactions)
- Money market hedges (using financial instruments to offset currency risk)
Let’s dive into these strategies and how they work in the real world.
What is Hedging? A Simple Explanation
Hedging is like buying insurance against currency fluctuations. Just as you would not drive without car insurance, companies operating in multiple currencies should not leave their profits to chance.
A strong hedging strategy helps businesses:
- Lock in exchange rates for future payments or receivables
- Eliminate uncertainty in international contracts
- Reduce losses from currency depreciation
Now, let’s look at two key ways businesses hedge against currency risk.
Forward Contracts: Lock in Your Rate, No Surprises
A forward contract is a private agreement with a bank or financial institution to fix an exchange rate for a future transaction.
Example 1: Using a Forward Contract for a Receivable (Future Payment Inflow in Foreign Currency)
Scenario: A U.S. technology company signs a contract to sell software licenses to a European client, expecting a payment of €500,000 in six months.
Risk: If the euro depreciates, the company will receive fewer U.S. dollars when converting the payment.
How the Forward Contract Works:
- The company locks in an exchange rate today (e.g., 1 EUR = 1.10 USD) with a forward contract.
- In six months, when the European client pays the €500,000, the company converts it at the agreed rate (1.10 USD).
- The company receives exactly $550,000, avoiding any exchange rate losses.
Benefit: The company eliminates the risk of the euro weakening.
Drawback: If the euro strengthens, the company misses out on potential extra profit.
Example 2: Using a Forward Contract for a Payable (Future Payment Outflow in Foreign Currency)
Scenario: A U.S. manufacturing company signs a contract with a German supplier to purchase machinery for €200,000, payable in six months.
Risk: If the euro appreciates, the company will have to pay more in U.S. dollars.
How the Forward Contract Works:
- The company locks in an exchange rate today (e.g., 1 EUR = 1.08 USD) with a forward contract.
- In six months, the company buys €200,000 at the agreed rate and pays the supplier.
- No matter how the exchange rate moves, the company only pays $216,000, avoiding unexpected currency costs.
Benefit: The company avoids unexpected costs if the euro appreciates.
Drawback: If the euro weakens, the company still has to buy at the higher locked-in rate.
Money Market Hedges: Using Loans to Lock in Exchange Rates
A money market hedge allows a company to borrow or invest in a foreign currency today to avoid exchange rate risk in the future.
Example 3: Using a Money Market Hedge for a Receivable (Future Payment Inflow in Foreign Currency)
Scenario: A U.S. consulting firm signs a contract to provide services to a French company, expecting a payment of €300,000 in six months.
Risk: If the euro depreciates, the company will receive fewer U.S. dollars when converting the payment.
How the Money Market Hedge Works:
- Today, the U.S. firm borrows the equivalent of €300,000 in U.S. dollars from a U.S. bank.
- It immediately converts the borrowed U.S. dollars into euros at today’s spot rate.
- The company invests the euros in a short-term euro-denominated deposit or fund through its U.S. financial institution.
- In six months, when the European client pays €300,000, the company uses those euros to repay the loan, including interest.
Benefit: The company locks in today’s exchange rate and gets U.S. dollars upfront, eliminating exchange rate risk.
Drawback: The company pays interest on the U.S. dollar loan, which adds a financing cost.
Example 4: Using a Money Market Hedge for a Payable (Future Payment Outflow in Foreign Currency)
Scenario: A U.S. auto parts company imports raw materials from Japan and must pay ¥50 million in six months.
Risk: If the yen appreciates, the company will have to pay more in U.S. dollars.
How the Money Market Hedge Works:
- Today, the company borrows U.S. dollars in the U.S. at the current interest rate.
- It immediately converts the borrowed U.S. dollars into yen at today’s spot rate.
- The company invests the yen in a short-term financial instrument through its U.S. bank or brokerage.
- In six months, the investment has grown to exactly ¥50 million, which the company uses to pay the Japanese supplier, avoiding exchange rate risk.
Benefit: The company locks in today’s exchange rate and knows exactly how much U.S. dollars it will need to borrow.
Drawback: Borrowing in the U.S. means paying interest on the U.S. dollar loan, so financing costs must be considered.
Final Thoughts: Take Control of Currency Risk
Hedging is not just for banks and financial institutions—it is a crucial tool for businesses operating across multiple countries. I have seen firsthand how currency fluctuations can impact the bottom line, and having a strong FX risk management strategy can save a company millions.
Whether through forward contracts or money market hedges, businesses can protect themselves from unpredictable exchange rate movements.
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