foreign exchange hedging - cambridge...exchange rates. the figures quoted within this document are...
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What is a forward contract?
Foreign Exchange HedgingForward Contract vs Forward Extra
What is a forward extra?
Closed forward contract
Open forward contract
On expiry there are 2 scenarios with this product
Forward contract advantages
Forward contract disadvantages
Forward contracts are a type of hedging product. They allow a business to protect itself from currency market volatility by fixing the rate of exchange over a set period on a pre-determined volume of currency.
With increased levels of economic and political uncertainty, foreign currency markets can be volatile and unpredictable. For importers and exporters with foreign currency exposure, planning and forecasting can therefore be a challenge.
Foreign currency hedging is one way a business can protect itself from fluctuating currency rates. To help clarify the difference between the two most common hedging products, we look at forward contracts and forward extras.
We also review their advantages and disadvantages to help you determine which is the most suitable product for your business.
A forward extra is an alternative hedging contract that allows a business to buy foreign currency at a “protection rate” in the same way as a forward contract, whilst also providing the opportunity to receive a rebate at the expiry date of the contract. In addition, the same flexibility exists that you would have with an open forward.
The spot rate is outside of your rebate range, with the contract having already been drawn down.
The spot rate is within your rebate range, with the contract having already been drawn down.
In this scenario the contract has already been completed, the rate the business has achieved is the pre-agreed protection rate and no rebate is applicable.
In this scenario the contract has already been completed and the rate the business achieves is the better spot rate within the rebate range. As the contract has already been drawn down at the protection rate, the business receives a rebate to ‘make good’ back to the better rate.
A closed forward contract allows a business to buy or sell a pre-determined sum of currency on a fixed date in the future.
An open forward contract gives a business flexibility to exchange currency at any time within the contract period up to the value date.
□ Gives your business certainty over the exchange rate irrespective of the prevailing spot rate on maturity.
□ Helps a business protect its profit margins from foreign currency market downside.
□ If the currency market moves favourably the business is still committed to using its forward contract at the agreed exchange rate which could be worse than the current market rate.
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All products are offered on an Execution Only basis. The information and material provided in this document do not constitute an offer to sell or the solicitation of an offer to buy, any currencies or securities and must not be relied upon in connection with any investment decision or advice. Examples are provided for your information only and are not intended to predict future movements in exchange rates. The figures quoted within this document are for indicative purposes only.
Foreign exchange options can carry a high level of risk to your capital and are not suitable for everyone. If you are in any doubt as to the suitability of any foreign exchange product that you are intending to purchase from Cambridge Risk Management (UK) Ltd, you should seek independent advice if necessary. Cambridge Risk Management (UK) Ltd is authorised and regulated by theFinancial Conduct Authority in the conduct of designated investment business.
Disclaimer
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Forward extra advantages
Forward extra disadvantages
□ Provides the business with certainty and peace of mind over the exchange rate.
□ Gives the business the opportunity to take advantage of a better spot rate on expiry subject to the market being within the rebate range.
□ No premium is payable upfront which may be required with other options products.
□ The protected rate will always be less favourable than the forward contract market rate.
□ If the spot rate on the expiry date is outside of the rebate range, no rebate exists and you are committed to the protection rate.
Here’s an example:
Forward extra scenarios on the expiry date
However, Company ABC Ltd has budgeted at an exchange rate of 1.30 but wishes to benefit should the spot rate move higher within the contract period. The protection rate offered on the contract is 1.30 with a 6-cent rebate range to 1.36.
Company ABC Ltd needs to buy $1,000,000, selling GBP, to purchase goods in 6 months’ time. The forward rate for comparison is 1.31.
The spot rate is below 1.30 Company ABC Ltd achieves a rate of 1.30 to buy $1,000,000
The spot rate is 1.34 – within the 6-cent rebate range Company ABC Ltd has already completed the contract, buying $1,000,000 at a rate of 1.30. The benefit of the contract now means that the rate achieved becomes 1.34. As a result, a 4-cent rebate is sent to Company ABC Ltd.
The spot rate is above 1.36 Company ABC Ltd achieves a rate of 1.30 to buy$1,000,000
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To find out more about FX Options and how they could help your business mitigate FX risk, connect with our Risk Management Team
“Cambridge Risk Management” is a trade name used by Cambridge Mercantile Risk Management (UK) LTD. Cambridge Mercantile Risk Management (UK) LTD is authorised and regulated by the Financial Conduct Authority (FCA) number 596682. The company is registered in England and Wales, number 08363276 at 10th Floor, 71 Fenchurch St., London, EC3M 4BS. This document has been approved by Cambridge Mercantile Risk Management (UK) LTD for the purposes of S21 of the Financial Services and Markets Act 2000.