If you’ve read our guides on forward contracts and FX options, you’ll have a working understanding of the FX hedging instruments available to businesses managing currency risk. You know what a Forward does, why an Option costs more and when a Spot transaction makes sense.
But managing FX exposure risk requires more than just knowledge of instruments. The next step is therefore understanding how to put hedging into practice.
This guide covers the three hedging strategies used by finance directors to build that framework: natural hedging, transaction hedging and balance sheet hedging. Each plays a different role, a different level of complexity and a different point at which it becomes relevant. Many growing businesses encounter all three as their FX exposure increases, so it’s worth knowing them.
Natural hedging – a passive FX hedging strategy
Natural hedging is a passive FX risk-reduction strategy where a business offsets its currency risk by matching foreign currency inflows with outflows.
For example, if a company does a lot of business in euros, it can hold a euro-denominated account and pay suppliers and accept payments using that account – almost as if it trades through a separate European entity. Rather than treating FX risk management as a separate treasury activity, it integrates it into the business model itself. The cost of FX is in the conversion; natural hedging is a way of mitigating that cost and risk.
Automated FX platforms like Alt21 support natural hedging by allowing clients to hold a range of currencies within a single account. The suitability of any platform will depend on a business’s individual circumstances.
Easier in theory than reality
But the reality of matching FX inflows and outflows can be more difficult than it sounds. Natural hedging assumes your foreign currency inflows and outflows are:
- in the same currency
- in roughly similar amounts
- predictable in timings
For most UK SMEs, these conditions don’t always hold true.
For a business generating revenue in pounds that pays overseas suppliers in euros, natural hedging is of little use. It only records FX outflows.
Even companies with regular inflows and outflows in the same currency are likely to find a natural hedge imperfect. Timing gaps, volume mismatches and margin changes quickly reopen exposure. Natural hedging can reduce risk in certain circumstances but it doesn’t eliminate it.
Businesses may turn to financial hedging when a natural hedging programme becomes unmanageable or insufficient. Financial instruments can help manage known currency obligations, but they carry their own risks and may not be suitable for every business.
Verdict on natural FX hedging
Natural hedging is cost-effective in that it requires no financial instruments, but it’s rarely a complete solution for UK businesses. Most SMEs face a structural mismatch, like generating revenue in the UK while sourcing goods from Asia or Europe, which leaves a net exposure that natural matching can’t address. As a FX hedging strategy, it can be imprecise and difficult to manage.
When natural FX hedging is actionable
Your currency inflows and outflows are broadly balanced.
Transaction hedging – FX hedging for individual transactions
Important information: FX forwards can help to manage exchange rate risk, but they also create binding obligations and may involve margin requirements. Entering into a forward contract removes the opportunity to benefit should exchange rates move in your favour. FX options also carry risk. Before entering any FX product, you should consider whether it is appropriate for your needs and circumstances. Hedging products are not suitable for every business.
Transaction hedging is using Forwards and Options to hedge individual transactions to preserve profit margins on a per-transaction basis. It’s the most common active FX hedging strategy for growing UK businesses, and the most direct way to manage currency exposure on a particular transaction.
It might be a stretch to call signing a Forward contract or an Option alone a “strategy”. Transaction hedging moves from tactical to strategic when aligned with risk appetites, payment schedules, and layered execution, tying it into broader business operations and objectives.
Transaction hedging and risk
Before any instrument is selected or any rate is booked, the finance director needs a position on how much currency risk the business is willing to carry. That answer won’t be the same for every business, or even for every transaction within the same business.
A company with tight margins and predictable foreign currency costs may consider hedging a high proportion of its known exposure (80% or more), leaving little to market movement. It has the need (tight margins) and stability (predictable costs) to hedge to a high degree. This company might sign Forward contracts that cover a large majority of its upcoming FX commitments.
A business with more margin headroom, or one that actively wants to participate in favourable rate movements, might hedge 50-60% and leave the remainder unhedged. They have less need for certainty and can tolerate the market moving against them, or get a boost from a favourable movement. Both these companies are hedging strategically, based on their circumstances and needs.
Platforms like Alt21 provide tools for booking forward contracts and tracking hedge ratios in one place. Whether any platform is appropriate will depend on the business’s circumstances.
Layered execution
Layered execution is how finance teams add another level of sophistication to transaction hedging. Rather than hedging an anticipated exposure in a single booking, the business builds its hedge position in tranches over time, a portion now, a further portion in several weeks, and so on across the exposure window.
The effect is a blended rate across different market conditions, which removes the concentration risk of having timed a single hedge badly. A business managing quarterly supplier payments across a financial year might begin layering hedges for Q4 while Q1 is still settling. This amounts to a rolling programme that tracks the commercial calendar rather than reacting to it.
The successful execution of a layered strategy is difficult without real-time visibility on open positions, upcoming payments and currency balances. Integration with accounting software like Xero helps reduce execution errors.
Verdict on transaction FX hedging
Transaction hedging is how companies mitigate FX risk at the level of the individual transaction. Successful execution hinges on alignment with risk appetite, operational realities and business objectives via targeted hedge ratios.
Actionable when…
You have identifiable future payments or receipts where a movement in the exchange rate would materially affect your margin or your ability to price competitively.
To learn more about the specific instruments used in transaction hedging, read our guide on Currency hedging for businesses: spot, forward or option?
Balance sheet hedging – FX hedging to stabilise reporting
When a business holds foreign currency assets or liabilities, it is subject to revaluation risk. Revaluation risk is where these assets are translated into sterling (or other local currency) for financial reporting, and are subject to fluctuations in the exchange rate. Fluctuations a company’s P&L account can be a problem for a few reasons:
- If a company has debt facilities, they might need to maintain ratios, such as net debt to EBITDA, which negative currency revaluations can jeopardise
- Currency volatility can add noise to business performance assessments
- With large foreign currency assets and liabilities, budgeting and forecasting becomes difficult without assumptions on future exchange rates
Hedging can reduce these risks.
Balance sheet hedges
Finance teams may use FX forwards to help manage foreign currency holdings on the balance sheet. For example, if a business holds a substantial euro bank balance that will be reported in sterling, it may enter into a forward contract to sell euros at a fixed rate, settling on the reporting date. Subject to settlement and the terms of the contract, this can provide greater visibility over the sterling value of that balance regardless of how EUR/GBP moves in the interim, offsetting the revaluation movement on the asset.
Forward contracts create binding obligations and may involve margin requirements. They also remove the opportunity to benefit if exchange rates move favourably.
Natural balance sheet hedges
The natural hedging concept discussed earlier can also be used to hedge balance sheets. A business can reduce its balance sheet exposure structurally by matching foreign currency assets with foreign currency liabilities in the same currency. If you hold a large dollar receivable, having a dollar payable of similar size and timing offsets the revaluation exposure without using a financial instrument.
Verdict on balance sheet FX hedging
This strategy can support accounting stability and reduce the impact of revaluation movements on reported results, which may be relevant for businesses managing debt covenants or reporting to stakeholders. While it doesn’t always involve an immediate cash move, it makes a company’s net worth less subject to currency movements. Balance sheet hedging is common practice among firms with significant international operations or multi-currency holding accounts.
FX volatility can cause a budgetary headache. Make sure you have a solid plan in place to manage it for the upcoming financial year.
Actionable when…
Your business holds significant foreign currency balances or assets that must be reported in your consolidated accounts.
How FX platforms support multi-layered FX hedging strategies
A sophisticated finance function rarely relies on a single approach. Instead, it uses a combination: identifying natural hedges where possible, using transaction hedging to secure project margins and applying balance sheet hedges to stabilise reporting.
The challenge for growing businesses has traditionally been the administrative burden of tracking these different exposures. However, some automated FX hedging platforms including Alt21, can reduce the administrative burden by integrating with accounting software such as Xero, providing visibility on exposures and supporting reconciliation of open hedges. This can free finance teams up from manual data entry. Ultimately, whether any platform is appropriate for a business will depend on its needs and circumstances.
ALT 21 Limited is authorised and regulated by the Financial Conduct Authority (FRN: 783837) and is a company registered in England and Wales (number 10723112). The registered address is 45 Eagle Street, London WC1R 4FS, United Kingdom. This article has been produced by ALT 21 Limited for information purposes only. It does not constitute financial advice or an offer to sell or the solicitation of an offer to buy any products referenced. Hedging products are not suitable for every business. Before entering into any FX product, you should consider whether it is appropriate for your needs and circumstances. ALT 21 Limited assumes no liability for errors, inaccuracies or omissions. Eligibility criteria and terms and conditions apply to all products and services offered by ALT 21 Limited. Not all applications will be accepted.
