Currency hedging: How to manage your SME's foreign exchange risk
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Loading... - Ngina Limo
- 09 Aug 2022
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Modern technology has allowed businesses to internationalise their business processes. This, together with the fact that most governments compete to attract more businesses to their countries, has provided significant opportunities. This internationalisation has also created some risks. One of these is currency risk. Currency exchange rates are notoriously volatile. This can be a significant drag on a company’s bottom line if not managed correctly.
Luckily, there are some useful foreign exchange risk management tools one can use to hedge against currency volatility.
MARKET/SPOT TRADES
The best known and most common trade in forex is the spot trade. This is essentially a trade done on the current market price and is subject to market volatility. When brokers “secure” the rate for their clients, they are really purchasing the desired amount in foreign currency from the live market.
To protect themselves from market volatility, most brokers apply a spread (the difference between what rate they can buy it for and what rate they provide to their clients). In the most cases, this spread will work on a sliding scale, meaning the more money their clients send, the tighter the spread (the rate clients get will tend closer to the actual market/interbank rate).
The main convenience of this type of trade is the fact that it is market related, meaning that it is executed at the best market price at that time. There is also no lag or waiting time for this type of trade to take place as it is done instantaneously.
The only drawback, however, is the fact that once the rate has been secured/locked in, there is almost no way of reversing it without incurring a loss or a fee.
LIMIT ORDERS
The main purpose of a limit order is to establish a high or low point at which you are willing to trade. The two main types of limit orders are the “take profit” and “stop loss” orders.
TAKE PROFIT ORDER
Normally, when the rate is considered too low to trade, you would wait for it to improve. With a limit order, you can place an order with a broker to automatically trade for you at a predetermined rate once this rate becomes available.
The benefit of a take profit order is that a trader can take advantage of rate spikes as they happen, without the risk of missing out on any positive movements (trade orders are filled automatically as soon as the desired rate becomes available).
Perhaps the biggest downside to a trade order is that it can potentially have a lengthy execution time. The desired rate may never be reached in certain cases. You would therefore have to be very certain of the timeframe of your trade. These limit orders fall in the realm of “set and forget”, where you are more set to obtain a certain rate instead of aiming to get it done quickly. Read More…
