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6 BENEFITS OF INCORPORATING FX HEDGING SOLUTIONS

This article is written by GPS Capital Markets As companies expand and start doing business internationally, they often engage in cross-border transactions, exposing themselves to currency exchange rate fluctuations. Currency exposure risk is an inherent outcome of engaging in the FX market. This uncertainty can impact transactional cash flows, making it imperative for corporations to employ effective risk management strategies. One such crucial strategy is Foreign Exchange (FX) Hedging. It is crucial to understand that the purpose of hedging practices is not profit generation. The primary goal is to safeguard the company and prevent significant financial losses. So, what is FX hedging? FX hedging involves the use of financial instruments to offset or reduce the risk associated with currency exchange rate movements. There are a variety of common instruments corporations use to hedge, such as forward contracts, options, swaps, and netting. We’ll dive in further on these individual instruments later. The Role and Benefits of FX Hedging There are significant benefits that come along with the time and implementation of having GPS Capital Markets come in and advise each of its clients about their FX exposure risk. Let’s discuss why this is such an important aspect of how each multinational corporation does business. Hedging your cash flows is crucial to managing financial risks and ensuring stability and predictability by protecting the company from adverse movements. Hedging can also allow for better budgeting and financial planning, as it provides a degree of certainty for future cash flows. This is particularly important when dealing with international transactions, where you can be subject to significant fluctuations and need to protect your profit margins. Better predictability also leads to greater confidence in management to make strategic decisions related to investments, expansions, and other business initiatives. Something often not considered is the benefit of improved relationships with creditors, which leads to potentially lower borrowing costs. Creditors love the predictability they can see with future cash flows. Lastly, hedging activities are often subject to accounting and regulatory standards. Properly executed cash flow hedging can help the corporation comply with these compliance standards and provide accurate financial reporting. In summary, 6 of the main benefits of incorporating an FX hedging program are: 1. Risk Mitigation 2. Financial Stability 3. Budgeting and Planning 4. Protecting Profit Margins 5. Enhancing Creditworthiness 6. Compliance and Reporting Hedging Instrument Definitions Knowing the overall benefits FX hedging can provide to corporations, let’s define each of the different hedging instruments that are commonly used among GPS clients. Forward Contracts: A forward contract is an agreement between two parties, a buyer and seller, to exchange a specific amount of currency A for currency B at a future maturity date. The exchange rate (forward rate) is determined at the time of entering the contract and reduces exposure to fluctuations in currency rates. Options: An option is a financial derivative that gives the holder the right, but not the obligation, to buy or sell a specified amount of one currency in exchange for another at a predetermined exchange rate (the strike price) within a specified period of time. There are two types of options commonly used, a call option and a put option. Call Option: A call option gives the holder the right to buy a specified amount of the base currency (the currency being bought) at the agreed-upon exchange rate (strike price) before or at the option’s expiration date. The seller (writer) of the call option has the obligation to sell the specified amount of the base currency if the holder chooses to exercise the option. Put Option: A put option gives the holder the right to sell a specified amount of the base currency at the agreed-upon exchange rate (strike price) before or at the option’s expiration date. The seller (writer) of the put option has the obligation to buy the specified amount of the base currency if the holder chooses to exercise the option. FX options have a specific expiration date, after which the option is no longer valid. The holder must decide whether to exercise the option before or on the expiration date. Unlike forward contracts, options provide the holder with the flexibility to choose whether or not to exercise the option. If market conditions are favorable, the holder may choose to exercise the option; otherwise, they can let it expire. So, you wonder, why wouldn’t you always take the more flexible route and always book an option? There is a premium that is paid to the seller for the right to exercise the option. It is the cost of purchasing the option and is determined by the exchange rate, time till expiration, and market volatility at the time. Swaps: FX swaps or currency swaps refer to two different ways of managing forward contracts. The first one is when a company has a forward booking for a future date and needs to change the value date of that contract. In this situation, you can move the value date forward or backward with an FX currency swap. The second example involves changing the amount of a forward contract that a company has on its books. If a company needs to reduce the amount of a contract, they can sell the currency forward to reduce the outstanding amount of their hedge. This can be very beneficial for managing cash flows and financing needs in different currencies. Currency swaps are often used by multinational corporations to obtain a desired currency for a specific period without engaging in a spot foreign exchange transaction. This can be very beneficial for managing cash flows and financing needs in different currencies, without having to incur a transactional cost. Netting: Netting in the context of foreign exchange refers to a process that allows market participants to offset or consolidate multiple transactions or positions involving the same currencies, resulting in a single net amount for settlement. Netting can help reduce credit and liquidity risk by consolidating obligations, as well as reduce administrative complexities and costs for a corporation. Implementing FX Hedging Meeting with an FX advisor from GPS Capital Markets can…