The WHAT of Hedging

CalendarNovember 16, 2023

The WHAT of Hedging:

Choosing a hedging product or structure that aligns to your strategy and your hedging policy

The primary reasons why most people balance-sheet hedge are to protect gross margin and create cashflow certainty.

Your product selection, aligned to your currency hedging profile and risk appetite, will help you achieve those goals.

A wide array of products exists, and they produce different outcomes. They can be blended depending on your exposures and your goals.

We’ll explain the function of the main hedging structures here, starting with the forward exchange contract and moving to FX options and FX structured products. We cover them in greater depth in the WHAT discussion.

Forward exchange contracts: locking in a future rate

The forward exchange contract is the most basic hedging structure. It is effectively an agreement between the customer and Corpay to exchange a specific amount of currency at a future date at a predetermined rate. That rate is determined by the current spot rate and the interest rate differential between the two currencies.

Bear in mind that the rate is locked in, no matter where the market is on the date of settlement. If the market moves in your favour, you won’t be able to take advantage of it. But if the market moves against you, you are fully protected.

This product is really good in helping to create certainty, and is probably the most common hedging structure.

FX Options and FX structured products

There are three basic types of currency options: a protection option; a participation option, and an enhancement option. Each has different advantages and disadvantages, but the one you choose will be related to your business and your risk profile.

If you’re very conservative, or your business cannot afford a market move against you, you may consider protection and / or participation.

But if you're in a more complex business, and you understand the products and have the ability to absorb additional risk or deal with the unexpected, you might look at enhancement products.

With structured products, though, if you get something, you give something. You get to participate, to a point, on the upside, but if the rate reaches a certain level, you go back to the worst case.

The decision-making process

Your goals and strategy will determine your direction and inform your decision-making.

For example, if your business is a low gross margin business, and it is very difficult to change your price, you would likely predominantly select the forward exchange contract. That gives you certainty, and because you can’t change your pricing easily, the impact of foreign exchange movement could be material.

If you are at the other extreme, with a high gross margin and prices you can easily change, FX options could be a good alternative.

If you’re in the middle, with high margins and fixed pricing, or low margin with the ability to change your pricing, you might consider either forwards or options. This scenario gives you the flexibility to look at different types of products.

The scenario that fits your business situation can potentially guide you towards what product(s) you might consider.

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