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Having reduced the FX exposure as much as possible by discussion, negotiation and appropriate contract terms and natural hedges, residual FX risks may need to be hedged using the financial instruments available to banks.
 

To protect their customers against unfavourable FX rate movements banks have developed a number of FX risk hedging products based on the following three techniques:
 

•     Forward FX contracts

•     Currency options

•    Currency futures

All three techniques require the two parties to the deal to deliver unconditionally an agreed amount of currency on a fixed or determinable future date. Exceptionally, in the case of currency options there is no obligation to deliver the currency, only a right.

Forward FX Market Hedging

Once an exposure has been identified (and reduced where possible using internal offsetting methods of FX management), a company can create a cashflow in the opposite direction using the FX market. The FX exposure is hedged by the creation of an opposite, but otherwise identical, exposure, in terms of currency, amount and timing. This is called 'hedging', i.e. FX cashflows are counterbalanced or neutralised at a fixed FX rate.
 

EXAMPLE

Not hedging in Forward FX contract

Contract Value:  £1.0 million

 
French buyer asks its bank in France to pay the invoiced amount .

French bank buys £1.0 million with Euros at the Spot Rate of exchange on the FX Market.
 

This is not the best deal for the French buyer as he has risked strengthening against the Euro during the contract period. Also he does not know his Euro costs until time of payment.
 

Hedged approach

French buyer at time of placing contract looks ahead and sees that UK Sterling interest rates for the period are higher than French interest rates.

This implies that is weaker than the Euro in the Forward market.
 

It would be cheaper in Euro terms to buy forward at the time of placing the contract.

The alternative is to risk a stronger Sterling Spot Rate at the time of payment.
 

By buying Sterling Forward French buyer eliminates any adverse FX movement from the date of buying forward to the date of payment of the UK seller's invoice.
 

French importer is now certain of his FX costs from time of placing the contract.

As is at a Discount in the Forward market the Euro cost is not only fixed at the time of contract but also lower.
 

EXAMPLE

A UK-based exporter enters into a contract with a 

The goods are due to be delivered on 1 September and paid for on 30 September, four months after the contract was originally signed. The exposure profile as of 1 June is:
 

Currency: US dollars

Amount: $25,000

Payment: 30 September

Position: long
 

The exporter decides to fully hedge this exposure.
 

On 1 June, it arranges to sell Forward $25,000 to a bank for value 30 September, in return for receiving sterling at a pre-agreed exchange rate.
 

This creates an opposite (i.e. short) position, but otherwise identical in terms of currency, amount and timing. It is a short position because the exporter has sold currency that he does not yet have.
 

Most international trading transactions are hedged using the Forward FX market. Companies and institutions hedging capital transfers of fixed, known amounts on specific dates under their control have the additional choice of options or currency futures. Currency options are also a valuable hedging tool for the more experienced businesses with well developed currency cash management systems.
 

Speculators play by their own rules, but are not averse to protecting their downside risk when considered necessary.
 

Managing Supplier's FX Exposure

A supplier can hedge a transaction perfectly if the date and amount of payment for the sale is known in advance.  If the exact date of payment is not known, the supplier can use a:
 

•  Forward FX contract, or less probably

• Currency option (value date), or

•   Currency overdraft