Currency hedge
What is Currency hedge?
A currency hedge is a position or arrangement intended to reduce the effect of specified exchange-rate movements on assets, liabilities, or cash flows.
A hedge policy should identify exposure measure, target ratio, tolerance, instrument, tenor, roll schedule, counterparties, collateral, liquidity reserve, and governance. Hedging accounting currency does not necessarily hedge the underlying economic drivers of a multinational company, commodity, or liability.
Stress tests should include gaps, basis changes, collateral calls, counterparty failure, and mismatched market holidays.
The program should distinguish risk reduction from active views and attribute each under separate limits.
Exposure being hedged
An investor can hedge accounting value, expected cash flow, benchmark currency, liability, or economic exposure. These bases differ. A euro asset in a dollar portfolio creates translation exposure, while a company may earn dollars and report euros. A hedge should state the risk and horizon rather than assume security currency equals economic currency.
Common instruments
Forwards and futures lock or approximate future conversion, swaps exchange currencies across dates, and options set asymmetric protection for a premium. Foreign-currency borrowing can create a natural hedge. Instruments differ in liquidity, tenor, collateral, counterparty, rollover, basis, and accounting treatment. The cheapest visible spread may not produce the best full result.
Hedge ratio and policy
Full, partial, dynamic, or no hedge can be suitable depending on liabilities, volatility, horizon, expected cost, and governance. A strategic ratio avoids tactical prediction; active policy varies exposure. Rebalancing maintains the target as asset values and flows change, but adds turnover and can generate collateral needs after adverse moves.
Risks
A hedge can lose when the foreign currency strengthens, though the underlying translated asset gains. Mismatched amount, timing, currency, or instrument creates basis risk. Forward counterparties, settlement, leverage, collateral, liquidity, and capital controls matter. Hedging an uncertain future asset value can overhedge after a market decline and create net opposite exposure.
Practical implementation
Inventory exposures and cash flows, define target and tolerances, select tenors and counterparties, model carry and stress, and maintain liquidity. Net positions where legally and operationally valid. Reconcile derivatives to assets and collateral daily. Evaluate the combined portfolio, not hedge profit alone, and avoid representing reduced currency variance as elimination of total risk.
Sources and further reading
- Currency Management: An Introduction, CFA Institute
- Triennial Central Bank Survey of foreign exchange and Over-the-counter Derivatives Markets, Bank for International Settlements