FAQ

Do I, as an importer/exporter, have to hedge against exchange rate swings?

Companies engaged in international trade should hedge their currency risk. Thanks to the maturity of the Polish currency market, companies have access to a broad selection of hedging instruments, the most popular of which are FX, futures and option contracts.

What caused the much publicized currency option problem and what are ‘toxic options’?

The primary cause of the currency option problems lay in a fundamental lack of knowledge of the instruments transacted and potential losses. Exporters entered into speculative transactions in currency options after many years of zloty appreciation. Speculative transactions consisted in writing call options (i.e., assuming the obligation to deliver currency against receipt of zloty) in EUR PLN and CFH PLN for notional amounts that often exceeded actual or increased actual risk exposures. When the trend reversed, these options incurred considerable losses. For instance, a company had to sell euro and purchase zloty at a rate of 3.30, when the market exchange rate stood at 4.50. This is an example of irresponsible and speculative currency risk management.

What is meant by long and short positions in a futures contract?

A long position consists in buying a currency, stock, or commodity in anticipation of a future price increase when it may be sold for a higher price. A short position means selling an instrument in anticipation of a future price decline when it may be repurchased at a lower price.

Am I capable of constructing a currency hedge for my company given my knowledge of finance? Can I manage my firm’s currency risk on my own?

Knowledge of financial instruments and market mechanics, as well as a general overview of the market situation, may be insufficient to construct and manage a successful hedging strategy. For a strategy to be effective, the individual responsible will have very little time for other business activities as proper hedge management is extremely time-consuming. The reason lies in the volatility of the currency markets. Even a profitable currency hedge may turn negative, should the market trend change. Position monitoring, access to information and pricing tools, as well as professional knowledge are essential. The option toxic option “hedging” case study serves as a meaningful example – closing an out-of-the-money position early may have limited the losses.

What’s the difference between hedging and speculation?

Hedging transactions correspond with company’s actual currency exposures. This means that if a company receives €1m from its contractors each month, its monthly hedge position should not exceed this amount. The currency exposure of an importer is analogous. A company that buys $1m every month should not hedge an amount higher than its purchase liabilities. Increasing the hedge above the currency position is speculative and, in the event of adverse exchange rate movements, may result in losses on the currency exposure and the speculative transaction. Entering a currency position that is additive to the companies’ currency exposure is speculative – for instance, entering a long zloty position in the case of a Polish importer.

Are there perfect hedges?

In theory, buying a currency option may be considered a perfect hedge. Such transactions are comparable to taking out an insurance policy. In the event of adverse movements, the company has the right to exercise its “insurance policy” and convert currency at a more beneficial exchange rate. The downside risk of such a strategy is the high initial outlay in the form of a premium purchase payment. Additionally, the greater the uncertainty of the future exchange rate, the higher the option premium. The high cost of on option will reduce the profitability of a hedge, resulting in a loss. Each solution has advantages and disadvantages. As a result, constructing a proper, market-oriented strategy is all the more important.

Should I always hedge my currency position? When may I opt out of a hedge?

Every company, in accordance with its approved hedging policy, makes a decision to hedge its currency risk. The frequency and volume of hedges hinges upon several factors. First, the amount of currency turnover and the sensitivity to exchange rate swings is taken into account. Second, whether the potential currency differences have a material impact of the business’ profitability. A comprehensive hedging strategy should be developed and followed consistently. A properly constructed hedging strategy allows the hedger to insulate itself from adverse and capitalize on advantageous exchange rate movements.v

Why is hedging more popular and necessary now than in the past?

Greater volatility in the currency markets, including the market for the zloty, in recent years has increased the need for effective hedging strategies. If the market trends in a given direction for an extensive period of time, companies will tend to expect the trend to continue endlessly and forget about the underlying risks. At times of increased volatility, when the zloty exchange rate may vary substantially from day to day, as happened during the crisis, companies will incur exchange rate losses in the absence of hedging. Globalization has changed the way financial markets are inter-related and increased volatility as commerce becomes more dependent on global economic events. Keeping risk in check is all the more important.

Does debt in a foreign currency influence currency risk?

Using foreign currency denominated debt provides direct or indirect exposure to the currency market. A currency credit is similar to holding a short position in a currency. In order to pay the monthly installments one has to buy the currency, thus opening a long position. Essentially, the position of a creditor equates to that of an importer. Currency credit therefore increases currency risk, a concept that many companies are oblivious to.

Are accurate exchange rates forecasts possible?

The currency market has a history of moving in long directional trends and, therefore, provides an opportunity to profit from directionally correct long-term forecasts. However, exchange rates in the medium- and short-term may be highly volatile and move against the longer-term trend for prolonged periods. The velocity of exchange rate swings requires constant monitoring of open positions, despite accurate long-term trend estimates. A missed forecast costs you nothing, but a poorly constructed or timed hedge frequently translates into losses.