Know your position: FX Volatility, friend or foe?

The FX market is no stranger to volatility. Whether it is global economic or political uncertainties, or a country’s interest rate outlook, they all play out in the currency markets. The constant push and pull of both known and unknown information can lead to bouts of extreme volatility. FX traders love volatility. There are plenty of opportunities to enter and exit positions and make money. FX trading is not for the faint hearted however, it is easier to lose money than it is to make it. But how do businesses that are buying or selling goods and services in foreign currencies navigate their way through the challenges of managing FX risk? FX trading is not a core function for most businesses but yet the impact of the FX market can make or break a financial year. I have witnessed businesses being wiped out due to adverse FX movements such as the commodity exporter that saw commodity prices plummet at the same time as the FX rate soar, a catastrophic combination. On the other hand I have seen a business live to trade another year because it was sitting on significant gains from in-the-money FX hedges that were cashed up to offset the losses suffered in the core business.

There is a plethora of risk management approaches to FX risk. To start with there is the philosophical debate about whether to hedge or not. Some would say that it is a zero-sum game in the long run i.e. periods of currency strength will be offset by periods of weakness, therefore, there is no incentive to hedge, just live with the swings and roundabouts of the prevailing spot rate. Of course the question is whether a business can sustain periods of adverse currency movements long enough to stay in business and enjoy the good times. For those that do participate in FX hedging there are questions of how much to hedge, when to hedge, which financial instrument to use?

The NZD/AUD exchange rate in the last few months has demonstrated massive volatility strengthening 10c (>10%) in less than six months. For years the NZD was extremely weak against the high flying AUD. As every other economy was cutting interest rates following the GFC the Aussies were just digging up more of its natural resources and selling it to China. The global recession did not come to Australia. More recently there has been a significant change in the Australian economic outlook. Current account surplus has turned to deficit as its trading partners have slowed, forcing the Reserve Bank to loosen monetary policy. At the same time the better performing NZ economy has been able to sustain a removal of the post-recession super loose monetary policy conditions. As shown below the interest rate differential of NZ and Australia remains a clear influence on the exchange rate.

Aussie int rate diffs

 

The importance of the Australian economy to New Zealand means that there are a lot of NZ companies exporting to Australia that are having to manage the NZD/AUD exchange rate. Everyone has a view – some you pay for (treasury advisors, consultants) some you don’t (bankers, taxi drivers) but they all have one thing in common – nobody knows the future direction of FX rates. That’s not to say taking advice (paid for or otherwise) is not relevant. No advice will be right all of the time but so long as the view is well considered and relevant to your business then it is hard to be critical after the fact with the benefit of hindsight. Hedging buys a business the necessary time to adjust selling prices or supply contracts to the new FX level.

A fundamental aspect of FX hedging decisions is to quantify and understand the impact of FX movements on the business. By regularly making and updating foreign cashflow forecasts, capturing existing hedging in place and understanding the impact of FX movements on the unhedged component of foreign cashflows, a company is in a much better position to make informed hedging decisions. Whether it is a budget rate or a costing rate to protect knowing your position is essential for making better FX hedging decisions. One thing is certain – FX markets will always be volatile – the question is whether a company has enough visibility on its current position to make sound decisions about the future. Hedgebook is a tool that can help give a company the visibility it needs to make informed FX hedging decisions.

 

Hedge accounting fx options: time versus intrinsic value

FX options make up an element of many companies fx risk management strategies. FX options lock in the certainty of worst case exchange rate outcomes while allowing participation in favourable rate movements. In my experience, companies are often reluctant to write out a cheque for the premium so for many the preferred strategy is collar options. A collar option involves writing, or selling, an fx option simultaneously as buying the fx option in order to reduce premium, often to zero.

After transacting the fx option, the challenge comes for those that are hedge accounting and the requirement to split the valuation of the fx option into time value and intrinsic value. IAS 39 allows the intrinsic value of an fx option to be designated in a hedge relationship and can therefore remain on the balance sheet. The time value of the fx option is recognised through profit or loss.

The intrinsic value of an fx option is the difference between the prevailing market forward rate for the expiry of the fx option versus the strike price. We can use an Australian based exporter to the US as an example. In our example the exporter forward hedged US$1 million of export receipts six months ago (the USD income is due to be received in three months’ time). At the time of hedging the AUD/USD rate was 0.8750 and the nine month forward rate was 0.8580. The company chose to hedge with a nine month zero cost collar[1] (ZCC). Six months’ ago the ZCC might have been as follows:

  • Option 1: Bought USD Put / AUD Call at a strike of 0.9000
  • Option 2: Sold AUD Put / USD Call expiring at a strike of 0.8000

AUD USD

The intrinsic value of each leg of the collar will be determined by the difference in the forward rate at valuation date versus the strike rates. For option 1, the bought option, if the forward rate is above the strike of 0.9000 then the fx option will have positive intrinsic value i.e. it is “in-the-money”. It is important to note that the intrinsic value of a bought fx option cannot be negative. The purchaser, or holder, of the fx option has all of the rights and would not choose to exercise the fx option if the market rate was below the strike price. They would simply choose to walk away from the fx option, let it expire worthless, and transact at the lower market rate.

For the sold fx option the opposite is true. If the forward rate is below the strike price (less than 0.8000 in our example) then the exporter, as the writer of the option, will be exercised upon and the difference between the market rate and the strike rate will be negative intrinsic value. Intrinsic value of a sold fx option cannot be positive.

The time value of an fx option is the difference between the overall fx option valuation and the intrinsic value. By definition, time value is a function of the time left to the expiry of the fx option. The longer the time to expiry, the higher the time value as there is a greater probability of the fx option being exercised. A purchased fx option begins life with positive time value that decays over time to zero. A sold fx option begins life with negative time value and tends to zero by expiry date.

When hedge accounting for fx options the splitting of intrinsic value (balance sheet) and time value (P&L) does not have to be a time consuming exercise. At Hedgebook we like to make life easy so as part of the FX Options Held Report the valuations are automatically split by intrinsic value and time value. The screen shot below shows the HedgebookPro output using our Aussie exporter example. With the significant weakening of the AUD in the last six months we see the zero intrinsic value of the bought option at a strike of 0.9000 and very little time value as there is little chance of the AUD strengthening to above 0.9000 by the time the option expires by 30 June. The sold fx option has a large, negative intrinsic value. The exporter will be exercised upon and have to convert the US$1 million of receipts at AUD/USD 0.8000 versus a market rate of closer to 0.7600. There is a small amount of negative time value.

HedgebookPro FX Options Held Report  

FX Options Held Intrinsic_Time

HedgebookPro’s easy to use Treasury Management System calculates fx option valuations split into intrinsic and time value. This simplifies life for those that already use fx options and hedge account, whilst removing obstacles to hedge accounting for those that perceive the accounting requirements as too hard.

The IASB is looking to remove the requirement to split fx option valuations into intrinsic and time components which will simplify the hedge accounting process further, however, currently this appears to be a 2018 story, unless companies choose to adopt early. In the meantime, HedgebookPro provides an easy to use system to ease the pain of hedge accounting fx options.

[1] Premium received from the sold option offsets the premium paid on the bought option.

Calculating fx forward points

A common misunderstanding we often encounter relates to the calculation of foreign exchange forward points. Foreign exchange forward points are the time value adjustment made to the spot rate to reflect a future date. The forward foreign exchange market is very deep and liquid and is used by an array of participants for trading and hedging purposes. In the corporate world many importers and exporters hedge future foreign currency commitments or forecasts using forward exchange contracts (FECs).

The table below shows a selection of the forward points and outright rates for a number of currency pairs:

Forward points

Table 1: Forward points and outright rates

For example the NZD/USD 1-year forward points are currently -270, while the NZD/USD spot rate is 0.8325. Therefore, at today’s rates a forward rate of 0.8325 – 0.0270 = 0.8055 can be secured for a commitment or forecast in one year’s time. But how did the NZD/USD 1-year forward points come to be -270? The common misunderstanding is that they are traded like the spot rate i.e. based on currency traders’ views for the outlook of a currency’s fundamentals. This is incorrect. FX points are mathematically derived by the prevailing interest rate markets. Using our example of the NZD/USD 1-year forward points the -270 is a result of the 1-year US and NZ interest rate outlook. The NZD/USD is a good example because of the significant interest rate differentials between the two currencies. The aggressive monetary easing policies in the US have resulted in an extremely low interest rate environment. This contrasts with NZ which although has interest rates at historically low levels, they remain well above those of the US. The chart below shows the NZ interest rate yield curve versus the US and the corresponding fx forward points.

NZ and US int rates and fx points

Chart 1: NZ and US interest rates and the NZD/USD forward points

The interest rate market is telling us that the US 1-year swap rate is 0.25% while in NZ it is 3.45%. So how does this equate to -270 fx points?

Example

USD1,000,000 at a spot rate of 0.8325 = NZD1,201,201

If USD1,000,000 is invested for one year at a US interest rate of 0.25% per annum, at the end of one year USD1,000,000 is USD1,002,500.

If NZD1,201,201 is invested for one year at a NZ interest rate of 3.45% per annum, at the end of one year NZD1,201,201 is NZD1,242,643.

The equivalent exchange rate is NZD1,242,643 divided by USD1,002,500 = 0.8067.

0.8067 – 0.8325 = -0.0258 (or -258 fx points in the parlance of the fx markets).

The bid/ask spread of the fx and interest rate markets accounts for the 12 fx point balance. The example serves to provide a “back of the envelope” guide to calculating fx forward points and outright rates.

Even though the calculation of the forward points is mathematically derived from the interest rate market, interest rates themselves are the market’s expectation of the outlook for an economy’s fundamentals i.e. subjective. Therefore the fx forward points are derived from traders positioning on interest rate differentials.

Exporters from countries with higher interest rate environments such as New Zealand and Australia benefit from the negative forward points, while it is a cost to importers. An exporter wants a weak base currency so large negative forward points are an economic advantage. With an upward sloping interest rate yield curve (or more correctly positive interest rate differential) forward points will be more negative the longer the time horizon.

An importer wants a strong currency therefore negative forward points are detrimental to the hedged conversion rate. The impact of negative forward points is a reason that exporters often have longer term hedging horizons compared to importers because the impact of forward points are not penal.

Forward exchange contracts are therefore a flexible, and relatively easy to understand, hedging tool that is commonly used to bring certainty to those grappling with foreign exchange exposures and the volatility of the financial markets.

Scope for Recovery by Australian Dollar Limited as Labor Suffers

The Reserve Bank of Australia cut its key benchmark interest rate to a record low 2.50% earlier this year, highlighting the central bank’s concerns over the sensitivity of the Australian economy to turmoil in emerging markets.

When discussing Australia at the turn of the year, we suggested that: “Now, with rates at all-time lows, it’s a good moment to reflect on why we’re in the current predicament. After all, dovish monetary policy is only implemented when worries of an economic slowdown persist.”

These concerns were well-informed, as the Australian labor market has only deteriorated over the course of the year, forcing the Reserve Bank of Australia to cut its main interest rate to a record low of 2.50% at its August policy meeting. This is a significant step lower from the 4.75% rate employed as recently as November 2011; an aggressive rate cut cycle the RBA has employed, indeed.

Nevertheless, it’s evident that concerns surrounding Australia will continue. The country’s most important sector, mining, continues to show signs of slowdown, and government advisors have reluctantly admitted that the global commodity supercycle – driven by rapidly growing emerging markets – may be finished.

We continue to believe that the changing economic climate of Australia will play a negative influence on the Australian Dollar. The labor market remains a primary concern, and has proven to be a major negative influence on the Australian Dollar in recent months:

AUDUSD_unemployment

Over the past two-plus years, after the AUDUSD peak near $1.1100 in the summer of 2011, the RBA’s aggressive easing cycle, in part to help soothe fears over the labor distress, has driven the AUDUSD down to its lowest exchange rate since September 2010, below $0.9000 in August.

Further pressure on the Australian labor market, and thus the Australian Dollar, seems likely. Whereas the AUDUSD was quite stable near $1.0500 for several months while labor markets deteriorated, it’s clear that reality has set in. Despite several rate cuts since November 2011, Australia’s unemployment rate has increased from 4.9% in April 2011 to 5.8% in August 2013, the highest rate since August 2009.

Scope for recovery in the labor market is limited at best as long as the commodity cycle slowdown persists. Data compiled by the RBA in August showed that base metals prices, perhaps most indicative of economic strength in the mining sector, sunk to their lowest level since late-2009 by midyear, an ominous sign considering the time before prices had reached that level it was on the way lower by another 30% amid the global financial crisis of 2008.

RBA CPI

Base metals prices continue to be the guiding light for Australia – and should they remain subdued going forward, we suspect that dovish guidance will remain in place at the RBA, serving as a consistent, bearish influence on the Aussie for the remainder of 2013.

Steel, iron ore and coking coal

Chinese Growth Slows, Hurting Regional Trade Partners

Our last update on the Chinese economy expressed concerns over the future path of growth. The transition to the free market from a centrally-planned state has proven to be difficult as the government fights financial and political corruption, a growing middle class, and international pressure to liberalize its currency, the Yuan.

Chinese growth is slowing, but there’s nothing that the once frequently interventionist government is going to do about it. In part, growth slowed alongside lending activity, as the People’s Bank of China has maintained tighter monetary conditions for two main reasons: as it attempts to weed out illegal and corrupt banking practices that take place off companies’ balance sheets, “shadow banking.”

If only to consider the scope of this problem, on June, the interbank lending rate, overnight SHIBOR (local equivalent to LIBOR), rose by an astounding 578-basis points to 13.4%. In comparison, the 1-week SHIBOR rate rose by 292-bps to 11.0%; this inversion of the SHIBOR curve is a strong indication of extremely tight credit conditions. Typically, yield curves invert when liquidity is a problem; the fall of 2008 was plagued by this issue in the United States in particular.

In our last post regarding Chinese growth, we said, in a ‘tongue-in-cheek’ manner, that “There’s one major caveat to Chinese data that is truly inapplicable to any other global economic force: you just don’t know if you can trust it. Chinese data seemingly comes out of a black box, where Chinese government readings of the economy tend to outpace private sector readings, or even eclipse foreign government estimates of economic activity.”

Were those views ever vindicated: in June, the Chinese government said that so-called arbitrage transactions distorted trade figures in a manner favorable to stronger growth. From Bloomberg: “The transactions “resulted in abnormal growth in mainland-Hong Kong trade for a few months” since the fourth quarter, Shen Danyang, a Commerce Ministry spokesman, said at a monthly briefing today in Beijing. “Even if these arbitrage trades are not necessarily illegal, they are not fully compliant with regulations. That’s why the government has been concerned about this.”

As the government faces these issues and more on the way to opening up the Chinese economy even further, it’s evident that any new policies will be geared towards a more regulated, transparent economy. Accordingly, to prevent fueling a housing bubble (which is a concern now), the government is unlikely to implement further fiscal stimulus in the near-term. This has and will leave the economy weak in 2013:

China GDP

As long as Chinese growth remains in a rut, global trade will remain dampened and hopes for broader global recovery will be teeter. An ongoing concern for Australian policymakers, signs of slowing Chinese growth continue to weigh on the economy, where the Reserve Bank of Australia cut the main rate to a record low 2.50% in August.

The reasons behind the Reserve Bank of Australia’s rate cut are critically important, and are why we believe that, thanks to China, the Australian Dollar could remain under pressure in the interim.

Rate Differentials and Expected Policy Action by the RBNZ Keep the Kiwi Looking Up

Reserve Bank of New Zealand Governor Graeme Wheeler currently faces a problem. On one hand, exporters are losing their competitive edge as the New Zealand Dollar has strengthened. Industrialists have called for the RBNZ to try to keep rates pointed lower in order to weaken the currency. Certainly, ever since the Federal Reserve suggested that it might begin to normalize policy, New Zealand government bond yields have increased.

Given the implications of the Fed removing liquidity from global markets, bond markets have been under pressure. Considering that investors had piled into those assets with any yield over the past few years, these same assets – including New Zealand government bonds – have seen their yields spike higher faster than their policymakers can deal with (as seen in emerging markets).

Bond spread_NZDUSD

Over the past several months, the results of the Fed’s taper speculation have provoked the NZ-US 10Y yield to widen to their largest differentials all year. This will be important for future Kiwi strength: widening interest rate differentials are supportive of a stronger currency. The recent divergence could be due to the broader repricing of risk assets to compensate for a slower easing Fed. But domestic New Zealand data is pushing rates up higher naturally.

Rate increases_NZDUSD

Over the past three months, RBNZ Governor Wheeler has used his press conferences not to make a concerted attempt to weaken his currency but rather to highlight the optimistic points on the economy. In fact, currency swaps traders are near their most bullish on the New Zealand Dollar all year, with respect to the number of basis points priced in. If this pricing mechanism exceeds 90-bps, it will be closing in on its most bullish reading since the New Zealand Dollar peaked in the summer of 2011.

Why is this information useful for hedging? If the swaps market is pricing in future rate hikes by a central bank, it might be an appropriate time to hedge against further upside risk in the currency.


Roots of the Spreading Currency War: Part 2

Quantitative easing (QE) became the preferred non-standard policy tool among central bankers starting in 2007 as more and more large central banks reached the zero interest rate policy bound and were forced to become more creative. Regardless of where you stand on the issue, it goes without saying that without the implementation of QE, the global economy would still be in tatters. 

Over the past several years, the Fed hasn’t been alone in its efforts to weaken its currency to help domestic exporters. For example, the Bank of England has expanded its monetary base by five times since 2008; the Swiss National Bank implemented a currency floor for the Swiss Franc against the Euro to stabilize trade.

In 2013, the most notable offender has been the Bank of Japan, who in an effort to pull the country out of a two decade long deflationary spiral (Japan has been (in)famously mired in a more-than-two decades long deflation spiral) has pulled the rug from under the Yen quite literally. From January 1, 2008 to November 14, 2012, the Yen had rallied by +43.21% against the British Pound; +38.14% against the Euro; and +28.97% against the US Dollar. Since mid-November, when it became clear that Shinzo Abe would rise to power as prime minister, the Yen has been ‘competitively devalued’: it lost -20.42% to the British Pound; -26.69% to the Euro; and -23.52% against the U.S. Dollar.

Article 6

Clearly there is a distortive effect by ultra-easing policies on FX markets. The effects are not limited, however, as investors’ risk tolerance is completely altered. Consider the performance of the U.S. equity market the S&P 500 (yellow) compared to the size of the Federal Reserve’s balance sheet ($M) (white). The rally in U.S. equities – the benchmark for high-grade risky assets – can be wholly attributed to the rising Fed’s balance sheet, as the chart above implies.

Now that the BoJ has engaged in QE, the Nikkei 225 stock index is soaring, up +32% in 2013 thus far. With the BoJ’s QE plans in place for at least the next two years, investors will continue to jettison Yen-denominated assets in search of yield. But this brings us back to the earlier point about trade: the weaker Yen means that major trading partners, such as the United States, the Euro-zone, and Australia and New Zealand, will have to enact counter measures to prevent their domestic exporters from bearing the pain.

On several occasions early in the year RBNZ Governor Wheeler commented that the elevated New Zealand Dollar exchange rate was hurting the nation’s manufacturers, while noting his desire to “smooth the peaks” in the high yielding currency. These efforts have been minor thus far, and yet the New Zealand Dollar is barely dislodged. There’s little reason to think the RBNZ is going to be able to turn the tides anytime soon.

If there is one thing we can expect with a fair degree of certitude, it’s that competitive devaluations are here to stay for the next several years. The Fed is doing it, the BoJ is doing it, and as time passes, more and more central banks will be forced to engage in ultra-easy monetary policy.

Roots of the Spreading Currency War: Part 1

The global economy has seen fits of growth and contraction the past few years, with the developed Western economies struggling to regain solid footing. In the post-global financial crisis world, emerging markets, specifically the Asian-Pacific region, has been a driver for global growth. But if we step back from the trees and look at the forest, it’s clear that without central bank interventions, the global economy would be in much worse shape.

Since late-2011, if you turned on the TV, you probably heard pundits describe monetary policies being implemented around the world as stoking a “currency war” between developing economies. Mention the phrases “QE” and “currency war” in the same sentence and you’ll likely hear one of two answers: the Federal Reserve fired the first shots; while others, especially more recently, have pointed to the Bank of Japan as the most egregious offender.

Regardless if it was the Fed or the BoJ, the fact remains that most major central banks are currently engaged in or are moving closer to policies that result in the devaluation of their currency. Accordingly, it’s best to get acclimated with the idea of a “currency war” because it’s going to be showing up in newspapers and on financial television shows for the next several years. For good reason: the budding currency war impacts short-term speculators, bonafide hedgers, and long-term investors alike.

Recently, the Reserve Bank of New Zealand entered the fray, with Governor Graeme Wheeler acknowledging that the central bank had intervened in the market on various occasions since February. Reports have circulated that the RBNZ sold between N$30M and N$200M during its intervention efforts, which we can say retrospectively had short-term bearish implications for the Kiwi. Governor Wheeler has an incentive to try and weaken the New Zealand Dollar: its elevated exchange rate across the G7 currencies makes New Zealand products less competitive.

Macroeconomic theory states that a weaker domestic currency makes domestic goods more appealing to foreign consumers, who then consume more of the domestic good rather than their own country’s goods. The increased exports from the domestic country to the foreign country lead to a trade balance surplus, leading to higher growth in the domestic economy and weaker growth in the foreign economy. Thus, any form of an intentional devaluation to a currency – a competitive devaluation – is a shot fired in the currency war.

Article 5

While the RBNZ’s participation in the currency war will likely be a futile effort, the steps taken by the BoJ are far from immaterial. The combined efforts of the Fed and the BoJ alone the past few months have sent the aggregate global stimulus pool from $13,700B to near $14,000B between early-March and early-May. These policies are likely to continue into the near-future, with the Fed printing $85B/month to absorb agency MBS and U.S. Treasuries, while the BoJ has pledged to inject approximately ¥140T (¥7T/month).

What does this mean for the New Zealand Dollar? For one, it means that the RBNZ is a small fish in a pond with much bigger fish.

The next article takes a look at how QE distorts investor decision making, and how the BoJ’s interpretation of aggressive easing will impact the Asian-Pacific currencies.

Why Timing is Key for Hedging!

Just like everything else in life – from barbequing, to merging into traffic, to releasing new products during certain economic cycles – timing is absolutely crucial in hedging foreign exchange exposure. The best way to know when to hedge or not is by looking at a chart – yes, it’s that simple!

Take the NZDUSD pair from January 2003 to December 2009:

NZD/USD Spot Rate

In April 2005, the NZDUSD moved to new all-time highs, having broken the previous one set over a year earlier. At this time, it wouldn’t have been wise to hedge against further new highs; but taking on a hedge for a downside risk would have been reasonable. The same can be said about the NZDUSD in January 2009 – it had moved to its lowest exchange rate in over six-years – it might not have been appropriate to hedge against further downside risks, but instead more proper to hedge against upside risks (hindsight being 20/20, this would have been a wise idea).

For example, in January 2008, it would have been a good time for a New Zealand company hedge payments made in U.S. Dollars, because were the NZDUSD to depreciate in value, the more money the firm would have to pay. If in January 2008, the New Zealand company decided not to hedge US$10 million in payments due a year later, it would have seen its cost rise from N$12.5 million (NZDUSD = 0.8000) to N$20 million (NZDUSD = 0.5000). By not hedging, the New Zealand firm would have had to pay out an extra N$7.5 million!

The next blog post will illustrate how market positioning can be used in timing.

Hedging, and a deeper look into the types of Financial Hedges

One of the popular misnomers about hedging is that it is a costly, time-consuming, complicated process. This is not true!

At the end of the day, there are two different types of hedges: natural hedging and financial hedging. It is not uncommon for companies to use one or both methods to implement their hedging strategies in order to protect their bottom line from currency risk.

Natural hedging involves reducing the difference between receipts and payments in the foreign currency. For example, a New Zealand firm exports to Australia and forecasts that it will receive A$10 million over the next year. Over this period, it expects to make several payments totaling A$3 million; the New Zealand firm’s expected exposure to the Australian Dollar is A$7 million. By implementing natural hedging techniques, the New Zealand firm borrows A$3 million, while subsequently increasing acquisition of materials from Australian suppliers by A$3 million. Now, the New Zealand firm’s exposure is only A$1 million. If the New Zealand firm wanted to eliminate nearly all transaction costs, it could open up production in Australia entirely.

Financial hedging involves buying and selling foreign exchange instruments that are dealt by banks and foreign exchange brokers. There are three common types of instruments used: forward contracts, currency options, and currency swaps.

Forward contracts allow firms to set the exchange rate at which it will buy or sell a specified amount of foreign currency in the future. For example, if a New Zealand firm expects to receive A$1 million in excess of what it forecasts to spend every quarter, it can enter a forward contract to sell these Australian Dollars, at a predetermined rate, every three-months. By offsetting the A$1 million with forward contracts every month, nearly all transaction costs are eliminated.

Currency options tend to be favorable for those firms without solidified plans, i.e., a company that is bidding on a contract. Currency options give a company the right, but not the obligation, to buy or sell currency in the future at a specified exchange rate and date. Upfront costs are common with currency options, which can deter small- and medium-sized firms, but the costs are for good reason: currency options allow firms to benefit from favorable exchange rate movement. Like interest rate swaps, whose lives can range from 2-years to beyond 10-years, currency swaps are a long-term hedging technique against interest rate risk, but unlike interest rate swaps, currency swaps also manage risk borne from exchange rate fluctuations.

Exchange rate volatility can affect a company’s hedging strategy – the next post will cover why timing is key.