For investors and producers who participate in the global markets, currency risk is a very real consideration. Currency risk, also known as exchange-rate risk, emerges when foreign currencies unexpectedly appreciate or depreciate against one another. In the event that traditional correlations suddenly become stressed or irrelevant, once sturdy monetary relationships degrade―and currency risk runs rampant.
Fortunately, there are ways to actively manage exposure to inflated or deflated monies. One such method is to implement a forex hedging strategy using FX futures. If such a strategy is designed and executed properly, a business or asset may be well-insulated from an unexpected shift in the global currency markets.
Currency Risk 101: Investors vs. Producers
Both investors and producers are impacted by currency risk, but they’re exposed in different ways. Here’s a quick look at how each feels the strain of currency risk and can mitigate its negative effects via a strong forex hedging strategy.
Patrice the Producer
It has been a big year for Patrice, a Kansas wheat farmer who has a banner crop ready to go to market. Traditionally, a significant portion of Patrice’s high-grade hard red winter wheat harvest is exported to eager buyers in Canada. However, a flagging Canadian dollar (CAD) this season has many of these buyers searching for local alternatives.
Patrice is in a tough position. The production expense of the harvest is relative to the U.S. dollar (USD), not the weaker CAD. In turn, Patrice’s sunk costs translate into higher prices passed on to the Canadian buyers, putting Kansas wheat at a disadvantage to its Canadian counterpart.
However, all is not lost. If Patrice implements this forex hedging strategy, he can minimize the currency risk posed by the CAD:
- During planting season, a short position in the Canadian dollar FX futures contract is opened. This positions Patrice to financially benefit from any devaluations of the CAD vs. the USD.
- After the position is active, Patrice is wise to monitor policy decisions made by the U.S. Federal Reserve (Fed) and the Bank of Canada. In addition, keeping an eye on the aggregate economic situation north of the border is a good idea.
In the event the CAD decreases in value, gains will be realized from the short futures position. These profits will help to offset any spot market price cuts needed to sell Patrice’s wheat to Canadian customers.
Inez the Investor
For Inez, a U.S.-based international equities trader, Brexit has brought a bulk of currency risk. Heavily invested in London’s FTSE 100, Inez has realized solid profits in Britain’s stock market. Nonetheless, concerns remain about the potential impact of a tanking pound sterling. Because the fallout from Brexit could be substantial, it would be wise for Inez to adopt a forex hedging strategy via FX futures.
Inez’s exposure to currency risk is one that all participants in foreign markets must face. Even though the returns on international investments can be solid, a devalued local currency can wipe out gains. To illustrate, assume Inez timed the FTSE 100 perfectly on the long side and realized a rock-solid 12 percent annual return. Unfortunately, the gains came during the Brexit transition period, and the British Pound (GBP) finished the year down 15 percent vs. the USD.
Even though Inez’s stock-picking prowess in the FTSE 100 was rewarded, the plunging sterling generated a net loss. However, she could have been managed the risk with this currency hedge:
- After going long on the FTSE, Inez opens a short position in GBP FX futures. This provides insurance to the downside of the GBP/USD exchange.
- After the position is active, Inez would be smart to monitor Brexit developments closely. In addition, staying abreast of policy actions from the Fed and Bank of England is a necessary task.
By managing exposure to a plunging GBP, Inez has insulated the FTSE 100 long position. The beauty of the FX futures hedge is that it may be modified at any time. If risks posed by uncertainty become untenable, then positions may be flattened and profitability preserved.
Do You Need a Forex Hedging Strategy?
Are you a producer or investor who does business internationally? If so, currency risk can destroy your profitability. Don’t leave foreign exchange rate volatilities unchecked because the losses could be severe.
For more information on how FX futures can help you diversify your holdings, contact the currency pros at Daniels Trading today. With more than two decades in the markets, the Daniels team is ready to help you manage uncertainty with confidence.