A hedge program is most effective when it aligns with the way your company evaluates financial performance. In this blog, we provide an overview of three different hedge strategy types that companies often turn to.
To mitigate foreign currency risk, treasury will develop hedge strategies that deliver margin protection and minimize foreign currency gains and losses below the line. At a high level, there are three hedge strategy types that companies deploy:
- Budget hedge to lock in a budget rate
- Layering hedge to smooth rate impacts
- Year-over-year (YoY) hedge to protect the prior year’s rates (50% is likely achievable)
So, when should companies implement one strategy over the other? It depends on your management’s external reporting goals. For management – specifically, CFOs – seeking to own their company’s hedge program objectives and achieve desired results, it’s important to tie hedge programs to the company’s overall goals (even if a hedge program seems to perform well from treasury’s perspective).
Here’s an example of each strategy.
Budget vs. Layering vs. YoY Hedge Strategy
#1. Budget Hedge Strategy
In a budget hedge strategy, treasury places hedges for 80% of forecasted monthly foreign expenses. This strategy is based on exchange rates at the beginning of each year. Treasury will account for the remaining un-hedged 20% of foreign transactions at this year’s monthly rates.
The result: a hedge that locks in a large amount of expenses at a single predictable rate.
For companies that value driving predictability in the budget, this is the strategy for you.
#2. Layering Hedge Strategy
Another common hedge strategy is the quarterly layering strategy. It provides a smoothing or averaging effect to financial results.
For example, a company hedges 50% of next year’s revenue based on four quarterly hedge layers. The strategy smooths results between last year and this year’s accounting rates.
This strategy is good for companies who value maintaining steady results (as opposed to high gains or losses), effectively absorbing rate volatility.
#3. Year-Over-Year Hedge Strategy
In a YoY hedge strategy, treasury places hedges for 50% of forecasted monthly foreign revenue based on last year’s monthly accounting rate setting methodology. This locks in half of the revenue at last year’s rates. Treasury will account for the remaining un-hedged 50% of foreign revenue at this year’s rates. This results in a smoothing effect YoY.
In the example below, you can see a 10% rate shock YoY produces a 5% impact (smoothing) and 50% predictability (hedge rate at last year’s accounting rates).
For companies who evaluate performance based on YoY performance, this will be a good hedging strategy to consider.
Conclusion
Some organizations value smoothing rate impacts or protecting the budget. Others value protecting rates from the prior year. No matter which strategy you choose, it’s most effective when it matches your performance objectives.
For help selecting and implementing a hedge program, please give us a call.
CapellaFX integrates the entire hedging workflow, helping your treasury, accounting and management teams stay on the same page and provide accurate reporting up the chain. See how.
Written byalexandra-loppnow
FAQs
There are three recognised types of hedges: cash flow hedge, fair value hedge, and net investment hedge.
What are the three types of hedging? ›
There are three recognised types of hedges: cash flow hedge, fair value hedge, and net investment hedge.
Which hedging strategy is best? ›
The Bottom Line
Diversification, options strategies, and correlation analysis are some of the most effective strategies for creating a balanced portfolio. The most effective hedging strategies reduce the investor's exposure to market risk, without harming the opportunity to make a profit.
What are the three types of hedge transactions? ›
Learn about hedging and explore the three main types of hedging transactions in foreign operations: Cash flow hedges, fair value hedges, and net investment hedges.
Which is the best example of hedging? ›
For example, if you buy homeowner's insurance, you are hedging yourself against fires, break-ins, or other unforeseen disasters. Portfolio managers, individual investors, and corporations use hedging techniques to reduce their exposure to various risks.
What are the three common hedging strategies to reduce market risk? ›
At a high level, there are three hedge strategy types that companies deploy:
- Budget hedge to lock in a budget rate.
- Layering hedge to smooth rate impacts.
- Year-over-year (YoY) hedge to protect the prior year's rates (50% is likely achievable)
Hedging is an advanced risk management strategy that involves buying or selling an investment to potentially help reduce the risk of loss of an existing position.
What is an example of hedging? ›
Some common examples of hedging are using derivatives such as options or futures to mitigate losses, buying an insurance policy against property losses, etc.
What is hedging and its types? ›
In the stock market, hedging is typically achieved by using derivatives such as options, futures, and swaps. While hedging can help investors reduce their downside risk, it also involves additional costs, such as premiums for options and other derivatives.
How many hedging strategies are there? ›
Types of hedging strategies
Pairs trading: taking two positions on assets with a positive correlation. Trading safe haven assets: gold, government bonds and currencies such as the USD and CHF. Asset allocation: diversifying your trading portfolio with various asset classes.
2.2 Internal Hedging Techniques : i) Netting, ii) Matching, iii) Leading and lagging, iv) Price Variation, v) Invoicing in foreign currency, vi) Asset Liability Management. 2.3 External Hedging Techniques : i) Hedging through forward contract, ii) Hedging through future contract, iii) Hedging through options, iv) ...
What are the four operational hedging strategies? ›
Section 9 illustrates how operational hedging can be tailored to the specific operations strategy of the firm using techniques such as: tailored redundancy, dynamic pooling with allocation flexibility, chaining, and multi-sourcing.
What is the gold hedge strategy? ›
The hedge only protects against adverse movements in the relative value of the U.S. dollar as expressed in the U.S. dollar price of gold. By holding long gold futures contracts, investors stand to gain when the U.S. dollar loses value as expressed by gold.
Is hedging a good strategy? ›
As a trader, hedging can be a helpful option strategy in certain situations, depending on an individual's investment goals, risk tolerance, and market conditions. The primary purpose of hedging is to reduce or offset the potential risks of an investment or portfolio.
How many types of hedging are there? ›
Hedging is widely classified into 3 kinds, each of which will assist investors in making money by trading different commodities, currencies, or securities.
