Exchange rate risk

There are far more risks involved in dealing with currencies than pure exchange rate risk, and hedging does not always do the job.

There are far more risks involved in dealing with currencies than the pure exchange rate risk, and hedging does not always do its job either. With the introduction of more or less free-floating exchange rates, an entire industry was born - the industry of keeping these risks under control. Countless new products are launched every day that promise not only to eliminate risk, but also to generate a profit. Can this make sense? Where is the line between hedging and speculation? 

Strictly speaking, the problem mentioned above has existed since the moment cross-border trade in goods was born with the accompanying monetary economy, in specific changing prices for goods and currencies. The documented beginnings of price hedging date back to the 18th/19th century, when Dutch tulips were sold for an agreed price long before they were harvested, resulting in the first commodity futures. This means goods for money at a price at which both parties tried to eliminate the price risk. Did they succeed? 

At first glance, it is tempting to reduce the risk to the quality and quantity of the goods, which ultimately determine the price. On closer inspection, however, the following risks exist when buying or selling tulips, for example:

This example assumes cross-border trade in goods with different currencies, as is common practice in most cases today. However, precisely these problems still exist today and some of them are highly topical and controversial. Such as, for example, the issue of dealing with the loss in value of goods, see e.g. IAS 36.

This explanation is intended to show you that the exchange rate risk is just one of many in the entire value chain and that this usually lies with the buyer of the goods. If it is borne by the seller, the seller has included the hedging costs in the selling price. Nevertheless, every avoidable loss naturally hurts.

But risk and return are twins that are very difficult to separate.  Therefore: All risks can never be eliminated!

Hedging currency risks

Today there is an almost infinite number of so-called hedging products, which
a) are mostly offered by banks; and
b) have a derivative character, i.e. they are derived from an underlying transaction.

The buyer of a hedging instrument should always ask himself the following questions:
1. how does the product work and under what conditions (triggers) does what happen?
2. who earns how much and where?

Does this minimize or even increase or expand the risks? Keyword: to close a hole, a new one is dug somewhere else. And because nothing is free - as Adam Smith said - the new hole is often even deeper than the first.

Example

Underlying transaction: You have earnings in EUR and buy a machine from England for 300,000 pounds sterling (GBP), delivery in 3 months, payable on delivery. Exchange rate EUR/GBP today 0.8838 and forward 0.88338. (With all options there is still the settlement risk that something goes wrong with the payment. For example, the bank is bankrupt, someone enters 3,000,000 instead of 300,000, the money is paid into the wrong account or debited to the wrong account, etc.).

Conclusion

The best way to hedge currencies is still to match income and expenditure in the same currency. Where there is only a time difference, this can be bridged by e.g. swaps or money market investments / borrowings. However, this again involves additional counterparty risks. In any case, it is advisable to take a close look at the products on offer to see whether they are suitable for hedging. Otherwise, there may well be more risks in the end than if the transaction had remained unhedged.