This lesson explores the practical strategies treasurers use to manage FX risk, from internal techniques to external hedging with derivatives.

3.1 Internal Hedging Techniques
Internal hedging techniques are strategies used within the company to reduce FX exposure without using external financial instruments .

  • Natural Hedging (Matching): Offsetting inflows and outflows in the same currency by matching foreign currency revenues with foreign currency costs.

  • Leading and Lagging: Adjusting the timing of payments and receipts to take advantage of expected exchange rate movements.

  • Invoicing in Home Currency: Requiring customers to pay in the company’s domestic currency.

  • Netting: Offsetting intercompany payables and receivables to reduce FX exposure .

3.2 External Hedging with Derivatives
When internal hedging is insufficient, treasuries use external financial instruments to hedge FX exposure .

  • Forward Contracts: An agreement to exchange currencies at a predetermined rate on a future date. This is a common and straightforward hedging tool .

  • Currency Swaps: An agreement to exchange principal and interest payments in different currencies.

  • Currency Options: Contracts giving the holder the right, but not the obligation, to buy or sell a currency at a specified price.

  • Non-Deliverable Forwards (NDFs): Used for currencies with capital controls or restricted convertibility.

3.3 Understanding Spot and Forward Markets
The ACT syllabus  requires a detailed understanding of:

  • Spot Markets: The market for immediate delivery of currencies (typically T+2 settlement).

  • Forward Markets: The market for contracts to exchange currencies at a predetermined rate on a future date.

  • Linking Spot, Forward, and Future Spot Rates: Understanding the relationship between spot and forward rates, which is driven by interest rate differentials .

3.4 Managing Balance Sheet Exposure
Balance sheet exposures require careful management to minimise volatility in reported earnings . This involves:

  • Exposure Definition: Identifying which balance sheet accounts are subject to FX risk.

  • Hedge Execution: Using derivatives to offset the FX impact on balance sheet items.

  • Hedge Accounting: Ensuring that the hedging strategy is properly accounted for under relevant accounting standards .

 

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