7 Ways To Hedge Against Your Currency Risk Exposure!
With the continuing strengthening of the US Dollars after Trump elected as president, with the exchange rate heading to USD 1 to SGD 1.45, for those who are importing using USD as buying currency, you will be terribly exposed!
If you are already earning a thin margin on your product, this margin may be wiped out by this continuing strengthening of USD due to higher SGD you would need to convert to pay in USD at point of settlement.
Let me elaborate…
WHAT IS CURRENCY RISK?
Currency risk is the potential risk of loss from fluctuating foreign exchange rates when an investor has exposure to foreign currency or in foreign-currency-traded investments.
WHY IT MATTERS:
Currency risk is important to understand because foreign currency exchange rates can drastically change an investor’s total return on a foreign investment, despite how well the investment performed.
7 possible ways you can hedge against your Currency Risk exposure …
Let me try to explain in as layman’s term as possible…
The most common hedging strategies in this regard are listed below.
1. Matching currency flows: This is a simple concept that requires foreign currency inflows and outflows to be matched. For example, if a Singapore company has significant inflows in USD and is looking to raise debt, it should consider borrowing in USD.
2. Currency risk-sharing agreements: This is a contractual arrangement in which the two parties involved in a sales or purchase contract agree to share the risk arising from exchange rate fluctuations. It involves a price adjustment clause, such that the base price of the transaction is adjusted if the rate fluctuates beyond a specified neutral band.
3. Back-to-back loans: Also known as a credit swap, in this arrangement two companies located in different countries arrange to borrow each other’s currency for a defined period, after which the borrowed amounts are repaid. As each company makes a loan in its home currency and receives equivalent collateral in a foreign currency, a back-to-back appears as both an asset and a liability on their balance sheets.
4. Currency Swaps : This is a popular strategy that is similar to a back-to-back loan but does not appear on the balance sheet. In a currency swap, two firms borrow in the markets and currencies where each can get the best rates, and then swap the proceeds.
5. Forward Contract : simply a forward is a non-standardized contract between two parties to buy or to sell an asset at a specified future time at a price agreed upon today, making it a type of derivative instrument. The party agreeing to buy the underlying asset in the future assumes a long position, and the party agreeing to sell the asset in the future assumes a short position. The price agreed upon is called the delivery price, which is equal to the forward price at the time the contract is entered into.
6. Currency Futures : are a transferable future contract that specifies the price at which a currency can be bought or sold at a future date. Currency Future contracts are legally binding.
7. A currency option : is a contract that grants the buyer the right, but not the obligation, to buy or sell a specified currency at a specified exchange rate on or before a specified date. For this right, a premium is paid to the seller, the amount of which varies depending on the number of contracts if the option is bought on an exchange, or on the nominal amount of the option if it is done on the over-the-counter market. Currency options are one of the most common ways for corporations, individuals or financial institutions to hedge against adverse movements in exchange rates.
Hope the above helps.
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