currencyhedging

Currency hedging is a risk management practice aimed at reducing or eliminating the impact of exchange rate movements on cash flows, assets, or liabilities denominated in foreign currencies. It is commonly used by multinational companies, exporters, importers, financial institutions, and investors to stabilize earnings, cash flows, and balance sheets in the face of currency volatility.

Hedging typically targets three types of exposure: transaction exposure (near-term currency movements affecting specific receivables or payables), translation exposure (consolidation effects on foreign subsidiaries when reported in the home currency), and economic exposure (long-term impacts on a company’s market value from changes in exchange rates).

The main hedging instruments are forwards and futures (agreements to exchange currencies at a set rate on a future date), options (the right, but not the obligation, to exchange at a specified rate), and swaps (exchange of principal and interest in different currencies). Natural hedges, such as matching revenue and costs in the same currency or invoicing in the home currency, are also used. Hedging strategies can be static (a fixed hedge ratio over time) or dynamic (adjusted as exposure changes).

Costs and risks accompany hedging, including bid-ask spreads, option premiums, margin requirements, counterparty risk, and basis risk (the hedge not moving in perfect tandem with the underlying exposure). Hedge accounting under IFRS or US GAAP can reduce earnings volatility by aligning gains and losses of the hedging instrument with the hedged item.

Overall, currency hedging is about risk reduction rather than predicting currency movements, balancing potential protection against costs and imperfect effectiveness.