An FX hedge is a foreign currency trade that's executed for the purpose of protecting a current position or an upcoming currency transaction. While that may seem simple, hedging FX risk is a complex process.
First, the risk and timeframe need to be precisely defined so the hedger can choose the appropriate strategy. The hedger must then decide which derivative instruments are best suited to achieve the desired level of protection. FX forward contracts are often the best choice, as they can be customized for any size and time period. The next step is to consider whether a “standard” forward contract or a non-deliverable forward (NDF) contract is preferable.
The typical standard forward contract provides for delivery of a specified amount of currency on a specific date. With an NDF, there is no transfer of foreign currency. Instead, a payment is made from one party to another in line with the agreed-upon terms. With this in mind, let’s review the various benefits to standard and NDF forward contracts.
Benefits of Standard FX Forward contracts:
- Certainty in Exchange Rate. Forward contracts provide businesses with a fixed exchange rate, ensuring certainty about future cash flows.
- Tailored to Specific Needs. Forward contracts can be customized to meet the unique requirements of businesses. This means companies can hedge a precise amount of currency exposure over a specific time frame.
- Cost-Effective. Forwards typically do not involve transaction costs or margin requirements, making them a cost-effective solution for hedging FX risk compared to futures or options.
Benefits of Non-Deliverable Forwards (NDFs):
- Flexibility in Currency Selection. NDFs are particularly useful for hedging currencies with limited access to traditional forex markets. They allow businesses to hedge exposure to such currencies without the need for direct access to those markets.
- Reduced Credit Risk. NDFs are usually cash-settled, eliminating the credit risk associated with physical delivery. Settlement is in a freely convertible currency (usually USD), which makes it easier to transact.
- Customized Solutions. Like standard FX forward contracts, NDFs can be tailored to meet specific currency exposure requirements, allowing for precise hedging.
- No physical delivery. NDFs provide an efficient way to hedge against currency risk without the need for physical delivery of the underlying currency.
- Hedging against short term risks. NDFs can be particularly useful for short-term hedging (e.g. known-event risk like an Argentine election) as they are typically less expensive than longer-term contracts.
Standard FX forward contracts can be the best choice when dealing with “major” currencies, since they are based on access to the highly competitive global FX market (over $7 trillion in average daily volume). These currencies include the euro, British pound, Japanese yen, Australian dollar, and Canadian dollar. Clients should expect tight spreads for execution, even with large orders, in these currencies.
NDFs are often the best choice for hedging currencies with limited liquidity and market access, referred to as “exotic” currencies. Asia accounts for the most traded NDF currencies worldwide, with the largest volumes in the Korean won (KRW), Indian rupee (INR), and New Taiwan dollar (TWD). For these currencies, NDF volumes exceed turnover in other foreign exchange products including spot transactions. In Asia, sizable NDF markets also exist for the Chinese yuan (CNY) and the Indonesian rupiah (IDR), and to a lesser extent for the Malaysian ringgit (MYR), Philippine peso (PHP), and Vietnamese dong (VND).
Non-deliverable forwards are also useful for hedging Latin American and African currencies, as they tend to be illiquid and subject to various capital restrictions. The most actively traded NDF currencies in Latin America are the Brazilian real, the Mexican peso, the Chilean peso, and the Colombian peso. NDF contracts are also traded for a variety of other Latin American currencies, including the Argentine peso, the Peruvian sol, and the Venezuelan bolivar.
NDF markets exist because of currency non-deliverability offshore, and restrictions in onshore markets particularly for non-residents. Such restrictions are present in most emerging markets. They take various forms including underlying asset requirements for currency positions, restrictions on participants in currency markets, prudential and documentation requirements, and regulation on permissible foreign exchange products.
And while hedging FX risk is a complex process, that doesn’t have to stop your business from protecting a current position or currency transaction.
Pangea was created to provide simple access to hedging for companies who lack the resources to do it alone. Pangea’s platform helps you hedge FX risk, strategically manage your global FX accounts, and deliver FX payments virtually anywhere in the world. With Pangea, you can manage your FX all from one single platform.
Pangea uses Ai to put the same powerful strategies and tools used by Fortune 500 companies, such as financial derivatives and hedging instruments, in the hands of your treasury and finance team.
Schedule a demo today and see how you can protect your positions and currency transactions in just a few clicks.
Pangea Prime: Predictable, simplified FX management.