When was the last time you went on a plane? Probably, a long time ago! Let’s just take ourselves back to that point. Why did you get on a plane? There could be many reasons. Perhaps you went on holiday or maybe it was for a work meeting. In most cases, it is unlikely you went on the plane, purely just for the sake of it (ok, I’ll make an exception for the pilot and the crew). Going on a plane was a consequence of another decision you made to travel somewhere else. It’s unlikely the reverse is true, you went on holiday, because you wanted to take a flight.
For speculators in FX markets, it can be tempting to think that everyone is involved for the same reasons that we are, to generate a profit. In practice, many of those folks trading FX, are doing because they have to, as result of other decisions. For them trading FX is like their flight, and the objective of their flight is their everyday business. In the case of a corporate institution their everyday business could be literally anything, for a tech company it might be software, for a car company it’s building cars etc. Running a corporate institution across borders will inevitably involve having to do FX transactions, as part of your business.
Suppliers might be based abroad and you’ll have to pay them in a foreign currency. Clients could be abroad too, and you’ll receive payments from them in foreign currencies. For a large corporate, you’ll end of balances in a multitude of different currencies, aside from your home currency. How do you manage this currency risk?
You could just do nothing. However, this means that you’re implicitly taking risk, which may not be your objective! Let’s say you are US corporate and you have Japanese clients, and you have just received a large amount of JPY, so we effectively long JPY. We implicitly have a USD/JPY position. If when we repatriate the revenue, say in a few months time, if USD/JPY has gone lower by 5%, then we’ll be very happy to have waited to do the transfer! However, let’s say USD/JPY goes higher by 10%, then perhaps we’ll be less than happy…! If we had bought USD/JPY in the same amount at the start, this would have flattened our exposure (fully FX hedged), and hedged our risk from fluctuations in the FX rate.
Essentially if we had NOT hedged our position from the outset (FX unhedged), we would have implicitly taken a view that USD/JPY would go lower. If that is your view, that’s fine, but if it was done, so as to “not take a view”, that wouldn’t have been the right course. There is of course a space between being fully FX hedged and unhedged. We can choose to be partially FX hedged. We can also choose different types of strategies when it comes to our hedging, such as passive or active hedging, within a certain framework. We can have multiple objectives, such as reducing risk, but also to try to generate some P&L from our trading activity.
Not everyone trades FX for speculative reasons. Corporates need to trade FX as part of conducting their business. Understanding how to manage their FX risk is important. Simply ignoring FX hedging can result in taking on a lot of risk, which may not be the intentional. We need to think carefully about how hedging FX exposure can reduce this risk. If you’re a corporate and have any questions about this let me know!