Currency Risk Management: Hedging FX Exposure

Currency risk can turn a profitable sale into a loss, or make a competitive supplier suddenly expensive. The challenge is that currency movements are unpredictable—expert forecasts are often wrong, and volatility can spike without warning.

The goal of currency risk management isn't to profit from FX movements—it's to reduce uncertainty so you can focus on your actual business. This means accepting that you'll sometimes be better off unhedged, but gaining predictability that enables better planning.

Types of Currency Exposure

Transaction Exposure

Transaction exposure arises from specific contractual commitments denominated in foreign currency. When you invoice a European customer in EUR or pay a Chinese supplier in CNY, you have transaction exposure.

• Accounts receivable: Invoices in foreign currency that may be worth more or less when collected
• Accounts payable: Foreign currency obligations that may cost more or less when paid
• Committed transactions: Future orders, contracts, or forecasted transactions

Translation Exposure

Translation exposure affects companies with foreign subsidiaries. When you consolidate financial statements, foreign subsidiary results are translated to your reporting currency at current rates, creating book gains or losses.

• Income statement: typically translated at average rate for the period
• Balance sheet: translated at period-end rate
• Cumulative translation adjustment: captured in equity

Economic Exposure

Economic exposure is the long-term impact of currency movements on your competitive position. Even if you transact entirely in USD, you have economic exposure if competitors price in other currencies or your customers' purchasing power depends on exchange rates.

• Competitive pricing: Currency moves can make you more or less competitive versus foreign rivals
• Customer purchasing power: Strong USD can reduce foreign customer budgets in their local terms
• Sourcing costs: Even if you pay in USD, suppliers may adjust prices based on their local costs

Measuring Currency Exposure

Before hedging, understand your exposure. Map your currency cash flows to identify net exposure by currency.

Exposure Mapping

Exposure Categories

• Committed: Existing invoices, contracts, POs—high certainty
• Forecasted: Expected future transactions—medium certainty
• Strategic: Long-term business plans—lower certainty

Hedge committed exposure more aggressively (80-100%), forecasted exposure moderately (50-75%), and strategic exposure conservatively (0-25%) or not at all.

Natural Hedges

Before using financial instruments, look for ways to reduce exposure operationally. Natural hedges have no premium cost and are often the most effective approach.

Natural Hedging Strategies

• Match currency of revenues and costs: If you earn EUR, source from EUR suppliers
• Invoice in USD: Shift currency risk to customers by invoicing in your home currency
• Netting: If you have both EUR inflows and outflows, net them before hedging
• Leading and lagging: Accelerate collection or delay payment based on currency direction
• Local operations: Establish local entities with local currency cost bases

Financial Hedging Instruments

Forward Contracts

A forward contract locks in an exchange rate for a future transaction. You agree to buy or sell a specific amount of currency at a set rate on a specific date.

• Cost: No upfront premium, but rate may be worse than spot
• Flexibility: Low—must settle at maturity, though can be rolled
• Best for: Known future transactions with specific dates
• Accounting: Can qualify for hedge accounting if properly documented

Currency Options

Options give you the right (not obligation) to exchange at a specific rate. You pay a premium for this protection but benefit if rates move favorably.

• Cost: Premium (1-4% of notional typically), paid upfront
• Flexibility: High—can let option expire if rates are favorable
• Best for: Protection against adverse moves while keeping upside
• Accounting: Can qualify for hedge accounting; premium amortized

Comparing Instruments

Building a Hedging Policy

A hedging policy establishes guidelines for when and how to hedge. Without a policy, hedging decisions become ad hoc and inconsistent.

Policy Components

• Exposure threshold: Minimum exposure before hedging (e.g., $250K per currency)
• Hedge ratio: Target percentage of exposure to hedge (e.g., 50-80%)
• Instruments permitted: Forwards, options, or both
• Tenor limits: Maximum hedge duration (e.g., 12 months)
• Counterparty requirements: Approved banks and credit standards
• Approval authority: Who can execute hedges and at what size

Sample Policy Framework

Implementation Considerations

Working with Banks

• Establish FX trading lines with your banking partner
• Understand credit requirements (may need to post collateral)
• Get competitive quotes—pricing varies significantly
• Consider using an FX broker for better execution

Accounting Implications

• Hedge accounting: Qualifying hedges can match P&L timing with underlying exposure
• Mark-to-market: Without hedge accounting, derivatives create P&L volatility
• Documentation: Hedge accounting requires formal documentation at inception
• Effectiveness testing: Ongoing testing required to maintain hedge accounting

Common Mistakes

• Over-hedging: Hedging more than actual exposure creates speculative position
• Under-hedging in volatile periods: Waiting to hedge until rates move against you
• Not netting exposures: Hedging gross rather than net exposure increases costs
• Speculation: Trying to time the market rather than reducing risk