Currency Hedging

Currency Hedging

Currency hedging helps investors protect capital from unexpected changes in currency exchange rates. Hedging is like an insurance policy that limits the impact of foreign exchange risk on financial markets.

Investors hedge their capital by purchasing contracts locking the future rates without affecting their liquidity.

The various hedging mechanisms range from basic to extremely intricate. When considering a hedging strategy, the most prudent first steps would be to define potential currency risks and based on that, evaluate what goals to set and what actions to take to mitigate these risks.

How Currency Swaps Work

One of the most popular currency hedging tools is a "currency swap." It is a financial instrument that involves the exchange of interest in one currency for the same in another currency.

Currency swaps comprise two payments exchanged at the beginning and end of the agreement. These payments are determined as a principal amount plus interest rate payments. However, a principal amount never gets paid. It's strictly theoretical. Principals are only used as a basis on which to calculate the interest rate payments in currency swaps.

Examples and calculation of currency swaps

If we consider two companies from different countries, their payments and swaps may be in different forms.

  1. A US company is looking to open a €5 million plant in Spain, where its borrowing costs are higher in Europe than at home. Assuming a 1.2 EUR/USD exchange rate, the company can borrow €5 million at 4% in Europe or $6 million at 2% in the US. The company borrows the $6 million at 2% and then enters a swap to convert the dollar loan into euros. A company from Spain, the counterparty of the swap a Spanish company that requires $6 million. Likewise, the Spanish company will be able to attain a cheaper borrowing rate domestically than abroad. Let's assume that it can borrow at 1.5% from banks within the country's borders. At the outset of the contract, the Spanish company gives the US company the €5 million needed to fund the project, and in exchange, the US company provides them with $6 million. Subsequently, these two companies will swap payments every six months for the next two years (the length of the contract). The Spanish firm pays the US company the sum that's the result of $6 million (the notional amount paid by the US company to the Spanish firm at initiation), multiplied by 2% (the agreed-upon fixed rate), over a period expressed as 0.5 (180 days ÷ 360 days). This payment would amount to $60 000 ($6 million x 2% x 0.5). The US company pays the result of €5 million (the notional amount paid by the Spanish company to the US company at initiation), multiplied by 1.5% (the agreed-upon fixed rate), and 0.5 (180 days ÷ 360 days). This payment would amount to €37 500 (€5 million x 1.5% x 0.5).The two parties would exchange these fixed two amounts every six months. Finally, two years after the initiation of the contract, these two parties would exchange the notional principal amounts. Accordingly, the US company would "pay" the Spanish company €5 million, and the Spanish company would "pay" the US аcompany $6 million.
  2. The US company pays a fixed rate. The Spanish company pays a floating rate on another currency (based on a predetermined benchmark rate, such as LIBOR or the Fed Funds Rate).These modifications to currency swap agreements are usually based on the demands of the individual parties, types of funding requirements, and optimal loan possibilities available to companies.
  3. Both companies use a floating rate based on a benchmark rate.

2023-05-25 • Updated

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