Foreign Exchange Hedge Cards

Much like outright price exposures, most companies do not manage foreign exchange exposures on a contract by contract basis. They will utilize a hedge card in exactly the same fashion to mitigate risks in foreign exchange. Foreign exchange has the advantage over metals futures that exposures can be kept to zero if the company wishes due to the ability to trade positions down to the last cent.

An FX hedge card for outright exposure works in the same way as an outright price hedge card. The card will list all of a company's physical contracts that have a foreign exchange exposure where the FX rate has been fixed with the customer, so the amount of exposure is known.

Same as outright price hedge cards only showing contracts that have had their price fixed, and therefore should have a corresponding futures position, contracts that have not had their FX rates and price fixed will not appear in the foreign exchange hedge card because no foreign currency should have been bought or sold for that physical contract yet.

The FX hedge card will sum all of the physical purchase and sales with an exposure to foreign exchange, EUR for example, and give one net figure for the amount of Euros the company should have bought or sold. It will then compare this figure with the net position of the company’s holding of Euros. As contracts change or are amended the hedge card will catch any unhedged exposure and market action can be taken to bring the company exposure back down to zero based on the requirements of each physical contract.

Companies will run an FX hedge card for each different currency that they have an exposure to, however unlike metal hedge cards, FX hedge cards can combine exposures across different commodities if the company wishes.

Simple outright EUR/USD Hedge Card

It is important to note that the hedged position should be in the same direction as the physical position. The hedge for foreign exchange is to buy currency for a physical purchase and to sell currency for a physical sale. Here the company has a net physical position of long 784,760.85 Euros. This means the combined value of their physical purchases in Euros is larger than the combined value of their physical sales in Euros. The hedged Euro net position here indicates the company has correctly executed all of these hedges and holds a long position of 784,760.85 Euros. This gives them a zero exposure for Euros at this time.

Taking this example a step further, a change has been made to the highlighted physical purchase in the below table. The change on the physical contract has increased the Euros required for the purchase from 3,000,547.54 to 3,075,652.30. This means that the company needs to purchase an additional 75,104.76 Euros to remain square and not be exposed to further fluctuations in the EUR/USD exchange rate.

Hedge card identifies exposure

As the table shows, this corrective action has been taken, their hedged Euro position has reflected this action taken at market and the company is once again square on their Euro exposure. Using an FX hedge card like this will limit the time it takes to identify any errors related to foreign exchange. If a contract is adjusted and there is no request for an additional hedge, the FX hedge card will flag the exposure and it can quickly be identified if market action needs to be taken, or if it was an erroneous change to the physical contract.

It will also capture if foreign exchange hedges have been missed as when the physical contracts are priced, their foreign currency requirement will hit the hedge card. However if there was no foreign currency actually bought or sold at market, then the hedged currency line will not change, and the net position will move away from zero.

Similarly if a hedge request was actioned to buy or sell currency at market, but there were no changes on the net physical requirement, then it can quickly be identified if it was an erroneous hedge request that needs to be unwound, or if a physical contract simply needs to be priced in the system in order to filter through to the hedge card.

Much like the various prompt dates for metal futures, foreign exchange hedges will also have different settlement dates based on the expected dates payments are required, or funds will be received for physical contracts. FX hedge cards can therefore be taken one step further in detail to further reduce risk.

Before looking at an example of a multi-dated FX hedge card, we should talk first about the forward curve for currencies. Just like there is a forward curve in metals trading, there is a forward curve for trading in foreign exchange. Much in the same way that we trade different prompt dates for outright metals hedging, there are different value dates (settlement dates) for foreign currency trades. 

If you are buying Euros and selling USD and you need the funds in 2 days time, you are going to receive a different rate than if you need a settlement date 1 month/3 months/6 months in the future. The difference in rates between two dates in foreign exchange is called points. A negative forward rate means that you will receive a lower rate in the future vs. spot rates, and vice versa for a positive forward rate. The forward curve for FX rates is largely dictated by the difference in interest rates between the two countries and the market's view on those interest rates. 

These forward rates can be fairly stable when looking at countries with similar central bank policies, or volatile when comparing currencies that have very different monetary policy. For example, at the time of recording, the GBP/USD forward rate curve is very flat, largely because both the USA and Great Britain have similar interest rates and are both in rate cutting cycles. The current points for a 1-month GBP/USD position is around -0.750, and for a 1-year forward it is only -1.6. However, when you look at the current EUR/USD forward curve on a 1-month position it is +13.75 and for a 1-year forward it is +206. 

These differences in settlement dates depending on when you need to buy or sell currency are vital to take into account when executing hedges as they will impact the relative value you will receive. It is also important to remember the forward curve if you are ever quoting a customer an FX rate - if you indicate a spot rate to a customer, but then need to execute the hedge for 1 month in the future when you will be paying or receiving funds, the 1 month FX rate could be very different to the spot rate you quoted.

Multi-value date EUR/USD hedge card

In this example of a multi-dated FX card the company has split their EUR hedge card into the two dates it is expecting to pay for, and receive funds in Euros. Obviously most companies will have many more than two dates they have foreign currency exposures on. FX hedge cards can be designed to capture every single date a company has an exposure on if that is how they want to manage their risk. 

Because of this additional layer of risk, whenever expected payment dates, or dates you are expecting to receive funds change, the relevant desks must be notified if the contract is priced in a foreign currency. This could be as simple as a customer paying a few days late, or a larger move like a purchase that is priced being shipped 1 or two months later than expected. Your company may have to enter into carry trades for their foreign exchange positions based on the changing dates of your physical contracts. 

Here the highlighted Euro sales exposure has changed from 1,255,321.55 to an expected receivable of 1,301,254.65 - an increase of 45,933.10 euros. The company’s hedge card not only lets them know they need to take market action and sell the additional 45,933.10 euros to square their position but also on what value date they need to make the trade. If they were to sell the euros in January - their nearest receivable date then they would still have a spread risk between January and February when they would actually receive the funds.