As we approach a new calendar year, many of us dream of what the future will bring for our business. For those companies doing business abroad, it might be time to consider whether foreign exchange (FX) hedging could add peace of mind and a sense of stability to your business in the year to come.
What is an FX Forward?
FX hedging, also known as an FX forward, is a method used by companies to reduce or “hedge” their foreign exchange risk from potential transactions in foreign currencies. This is a global banking product that allows someone to lock in a foreign exchange rate with a counter currency, typically the currency of the person’s home country, for a specific future date. Basically, you lock in today’s rate, for whenever your future business transaction date is, eliminating many foreign currency risks.
For example, you may want to lock in today’s rate for a contract three months out involving the U.S. Dollar (USD) against the British Pound Sterling (GBP). This contracted rate would then be in effect for your foreign exchange transactions needing GBP on the specified date three months out. This means wherever the GBP sits versus the USD in foreign currency markets on that future date of payment will not matter for the contract since the price is already locked in. In other words, you have “hedged” your bets against any fluctuation of the USD against the GBP between the contract date and the payment date three months later.
When would your business use FX forwarding?
Here are several situations where you might benefit from locking in a foreign exchange rate against the USD:
- When there is greater uncertainty in the foreign exchange markets, specifically when a certain currency is fluctuating radically against the USD.
- Many companies come to a point in their business when you need to make a one-time larger payment in a foreign currency in the near to mid-term future and would benefit by knowing or accounting for the current cost in USD.
- FX forwarding is a great option for repetitive, pre-scheduled payments, like foreign payroll or taxes for a subsidiary or business unit abroad.
- When exporting a product or service and invoicing in a foreign currency, FX forwarding allows you to secure the exchange rate now to know your USD payment amount.
It is important to keep in mind that FX hedging does not mean that you will not lose on the exchange rate. An FX hedge simply locks in today’s rate, for a set date in the future. It is possible that the USD could be stronger against the foreign currency than the contracted rate in the future, meaning that had you simply exchanged currencies on the due date in the future, it would have cost you fewer dollars than the rate set in the FX forward. With that said, the FX hedging is still an important tool for minimizing your foreign exchange risk and allowing you to realize future expenses and profits in present-day, USD value.