Question from Paul: Doesn't hedging mean you surrender possible gains as well? Is it really worth it?
Michael Elliott: Hedging is meant to mitigate negative impacts to the underlying business. While there are generally costs involved, it doesn't necessarily mean you are giving up possible gains. When any adverse move causes fiscal pain, but positive moves are not necessarily offsetting, then the cost of hedging is definitely worth while. The vehicle used to hedge the currency risk can be structured to allow for participation in favourable moves. However, the hedge itself will have to be at a less favourable level. This means you do get to participate in the upside, but you have to be open to some of the downside as well.
Jean-François Lamoureux: This will depend on the proportion of a company's foreign exposure that is hedged and the type of hedging instrument used. It is true that with foreign exchange forward contracts ("forward"), possible gains are nil if the exchange rate moves in manner that is favourable for the company. This will be all the more true if a company has hedged 100% of its foreign exchange exposure. With a forward, the "cost" for the company (note: there is no out-of-pocket cost associated with purchasing forwards) of eliminating all of the risk tied to a negative evolution of the rate of exchange (from the company's perspective) is its inability to benefit from a positive movement in such exchange rate.
Contrary to forwards, currency options do allow firms to benefit from favourable movement in the exchange rate. However, they either involve an upfront cost or are structured in ways where companies have to accept some exposure to a negative movement in an exchange rate in order to reap some benefits if the exchange rate movement is positive for the company.
For the majority of companies, the goal of currency hedging should not be to generate incremental profits. Currency hedging should be seen as being first and foremost a risk management activity that aims to protect a companies' profit margins. In that sense, it is definitely worth it.
Brendan McGrath: Hedging foreign exchange risk with a forward contract does protect you against an adverse move in the currency but also means you cannot participate in a favourable move in that currency. Businesses hedge currency risk in order to protect budgeted rates rather than to make money on a currency move. While gaining the best rate on a hedge is always an attractive proposition for corporate treasurers, protecting the company's bottom line should be job number one. Any company with a foreign currency exposure should have a budgeted rate in mind that they target to protect, rather than speculating and waiting for the rate to improve. We all too often see companies choosing to wait for a currency to swing in their favour and end up locking in losses when that move doesn't materialize. An old adage that treasurers and risk managers need to remember is that no one has ever gone broke locking in profits. While hedging with a forward contract does not give you any upside potential, a currency option does give you the ability to protect your bottom line while allowing for upside gains as well. Currency options give the holder the right but not the obligation to buy or sell a currency at some time in the future. That is, they can protect their bottom line while still allowing for full participation in any favourable move. This flexibility does come with a cost however, and can sometimes be prohibitively expensive for cash poor organizations to afford. Options are akin to buying insurance on a currency in the hopes that you won't have to use it, but with the peace of mind that you are protected should the unforeseen event happen. Using an option strategy that combines the purchase and sale of an option can allow you to protect your bottom line while giving you a limited amount of participation in a favourable move, so hedging does not necessarily mean you have to give up any chance for gains. A robust hedging strategy is one that combines options and forwards as well as unhedged positions in order to provide the optimal result for the company. Companies with tight profit margins will usually hedge a larger proportion of their overall exposure as even a small move in a currency can impact their bottom line drastically. At the end of the day hedging, regardless of the tool used to do so, will provide value to an organization that is aiming to protect its bottom line.
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