Companies involved in foreign trade transactions are active participants in the global forex market worldwide. Exporters always need to sell, and importers to buy foreign currency. Exchange rates constantly fluctuate in the global forex market. As a result, the actual value of a product or a service bought with or sold for foreign currency may vary significantly, making an advantageous contract disadvantageous or even loss-making. Of course, the reverse situation when fluctuation of exchange rate makes profit is also true, but a commercial company is not tasked with deriving profit from exchange rate fluctuation. It is important for a commercial company to be able to plan the real cost of bought or sold goods so companies make a wide use of forex risk hedging in their business.Money as well as future income or expenses in foreign exchange is a subject to forex risk. A company normally keeps accounting records in one currency (e.g. U.S. dollars) thus profits or losses from revaluation of items denominated in foreign currencies are possible if their exchange rates change.
Forex risk hedging is a protection of funds from unfavorable exchange rate trends and consists in fixing the current value of these funds by entering into transactions in the FOREX market. Hedging results in disappearance of the exchange rate fluctuation risk for a company, which enables it to plan its activities and to see its financial result not distorted by rate fluctuations. Transactions in the Forex market are realized on the margin trading principle. This trading type has a number of peculiarities which made it very popular. A small initial deposit gives the possibility to trade with the amounts that are many (dozens and hundreds of) times lager than the initial deposit. This excess is called credit leverage. Trading takes place without any actual money supply, which reduces overhead charges and enables to open positions by both purchase and sale of currency (including the one that differs from the deposit currency). The peculiarity of forex risk hedging of using transactions without actual cash flow (with use of credit leverage) gives the opportunity not to extract significant funds from a company’s turnover.
Two major hedging types can be singled out – purchaser’s hedging and seller’s hedging. Purchaser’s hedging is used to alleviate the risk of potential growth in prices for goods. Seller’s hedging is applied in the opposite situation, to minimize the risk of potential decrease in prices for goods.
The overall hedging principle for foreign trade transactions consists in opening a forex position in a trading account with the view of a future cash conversion transaction. An importer needs to purchase foreign exchange, so the importer opens a position by purchasing foreign exchange in the trading account in advance. On the date of actual foreign exchange purchase in its bank, the importer closes the position. An exporter needs to sell foreign exchange, so the exporter opens a position by selling foreign exchange in the trading account, and on the date of actual foreign exchange sales the exporter closes the position.
Forex risk hedging through FIBO:
To take advantages of hedging, it is necessary to open a trading account with our company. The deposit amount should allow, subject to use of credit leverage, to open a position you need and to meet margin requirements if the market goes counter your position. If the market will continue moving counter your position you will have to make an additional deposit to maintain margin requirements.
Forex risk hedging fee:
As is known, one should always pay for risk reduction. Hedging gives rise to several expenditure items. Any transaction entered into the Forex market is connected with the costs represented by a difference between the purchase price and the sales price for a currency (spread). However, in the existing market environment this difference is normally equal to 0.05% - 0.1% of the transaction amount, which is insignificant. One has to keep a position open during a long period of time, and each day a position is moved to the following date (rolled over), taking into account interest rates on currencies participating in the transaction. In the current market environment, this fee is equal to 0.01% per day, or 0.3% of the transaction amount per month. However, depending on the direction of a transaction (purchase or sales), a customer will either pay or be paid this position transfer fee.
A guarantee deposit should be contributed to have a position opened. Its amount usually ranges from 1% to 5% of the concluded transaction amount. As soon as a position is closed, the deposit may be withdrawn from the trading account (with profit or loss).
Thus, the costs of hedging are quite minor as compared with the hedged contract values. Hedging is intended to reduce the risk of potential losses rather than to derive any extra profit. So hedging efficiency may only be evaluated taking into account the core lines of business of a commercial company. A well-developed hedging program does not only minimize the risk but also reduced costs by disengaging the company’s funds.
FOREX RISK HEDGING EXAMPLES
Example 1: Import of goods from Europe
A U.S. importer concluded a EUR 100,000 contract for supply of goods from Europe. According to the contract, the importer prepaid 30%, for which purpose he had to convert dollars into Euros at the current rate, which stood at 0.9867. He was supposed to pay the remaining EUR 70,000 upon receipt of goods. As the delivery was to be made in two months, there was a risk of incurring losses for the importer as a result of the euro appreciation vs the dollar. As the importer deemed it more important to fix the profit rather than to make profit if the euro falls vs the dollar, the importer resolved to buy the remaining Euro amount in the Forex market. To purchase EUR 70,000 in the Forex market with credit leverage 1:100, the importer only needed $700 but, in order to maintain margin requirements if the market goes counter him, the importer opened an account with the deposit of $3,000.
Euro rose in price to 1.0694 in two months. With a long EUR position (purchase position) opened, his profit in that position came to $5,824 (or EUR 5,446), which is equivalent to his losses on dollar cash
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