What FX hedging is
A hedge links a future foreign currency amount to a rate agreed now, or puts a limit on how bad that rate can get. It reduces uncertainty about the sterling value. It does not make the flow cheaper: if the market later moves the other way, the hedged amount misses that benefit. What is FX hedging gives a gentle introduction.
The main instruments
Spot
A spot trade exchanges currency now, usually settling within two working days. It is not a hedge in itself. Paying at spot on the day leaves the full amount open until then.
Forward contract
A forward fixes the rate today for an exchange on a set future date. The rate is the spot rate adjusted by forward points, which mostly reflect the interest rate difference between the two currencies. There is usually no upfront premium, but the business is committed to the exchange, and a provider may ask for margin or a credit line. Forward contracts explained and forward contract vs spot cover the detail.
Window forward
A window forward (sometimes called a flexible forward) fixes the rate but lets the business draw down the currency at any time within a date window, in one or several amounts. It suits flows whose exact date is uncertain. The rate is usually a little less favourable than a fixed-date forward because the provider carries the timing flexibility.
Option
A currency option gives the right, but not the obligation, to exchange at a set rate (the strike). If the market is worse than the strike, the business uses the option. If the market is better, it can let the option lapse and deal at the market rate. The cost is a premium, usually paid upfront. Some structures reduce or remove the premium by giving up part of the upside, which adds conditions that need to be understood before use.
FX swap
A swap combines a spot exchange with an opposite forward exchange. Businesses use swaps mainly to move the date of an existing position, for example when a payment is delayed, rather than to create new cover.
Natural hedge
A natural hedge uses the business itself: matching foreign currency receipts with payments in the same currency, invoicing in sterling, or holding a currency account to pay future invoices. It costs nothing in premiums but depends on timing and on customers and suppliers agreeing to the currency.
Trade-offs at a glance
| Instrument | Certainty of rate | Keeps upside | Upfront cost | Timing flexibility |
|---|---|---|---|---|
| Spot on the day | None until the day | Yes | None | Full |
| Forward | Fixed | No | Usually none | Set date |
| Window forward | Fixed | No | Usually none | Within window |
| Option | Worst case fixed | Yes | Premium | Set date |
| Natural hedge | Depends on match | Partly | None | Depends on flows |
Where the costs come from
Hedging costs are not always shown as a fee. The main components are:
- The spread between the rate a provider offers and the mid-market rate.
- Forward points, which can work for or against a business depending on interest rates. They are not a fee in themselves, but the spread is often applied on top.
- Option premium, paid for the right to walk away.
- Credit and margin, where a provider requires collateral or a facility.
- Operational cost of managing contracts, drawdowns and reporting.
Comparing the all-in rate against the live mid-market rate shows how much of the cost is spread. Live mid-market rates are on the FX.Exposure homepage and in the calculator.
How hedge ratios are discussed in practice
A hedge ratio is the share of an exposure that is covered. Businesses often set a range rather than a single figure, and cover more of the near-term flows (which are more certain) than the later ones. Committed flows are often treated differently from forecasts. The right range depends on margins, pricing power, cash and how much uncertainty the owners accept, so it is a business decision. How much FX exposure do businesses cover? explains the factors involved, and hedging currency risk in a small business looks at smaller firms. Limit and stop orders, which act at a chosen level, are covered in market orders explained.
Worked example (illustrative)
These figures are hypothetical, chosen to show the mechanics. They are not market quotes or a recommendation.
A UK business must pay USD 1,000,000 in six months. Spot GBP/USD is 1.30. An illustrative six-month forward rate is 1.295. An illustrative option with a strike of 1.25 costs a premium of £15,000. The table shows the sterling cost under three possible spot rates at the payment date.
| Spot at payment | Unhedged | 100% forward | 50% forward, 50% open | Option, strike 1.25 |
|---|---|---|---|---|
| 1.20 | £833,333.33 | £772,200.77 | £802,767.05 | £815,000.00 |
| 1.30 | £769,230.77 | £772,200.77 | £770,715.77 | £784,230.77 |
| 1.40 | £714,285.71 | £772,200.77 | £743,243.24 | £729,285.71 |
How the figures are built:
- Unhedged: 1,000,000 ÷ spot at payment.
- Forward: 1,000,000 ÷ 1.295, the same in every row.
- 50/50: 500,000 ÷ 1.295, plus 500,000 ÷ spot at payment.
- Option: 1,000,000 ÷ the better of the strike and spot, plus the £15,000 premium. At 1.20 the option is used at 1.25, so £800,000 plus £15,000.
The forward gives the narrowest range. The open position gives the widest. The option caps the worst case at a known cost and keeps most of the benefit if sterling strengthens. None of these is better in every row, which is why the choice is a matter of policy rather than prediction.
Budget rates and hedging
A budget rate is the rate used to plan costs and prices for the year. Hedging is often measured against it: cover at or near the budget rate protects the plan. Setting your FX budget rate explains common approaches. The wider process of deciding how much to cover is set out in FX risk management for businesses, and the measurement that comes first is in FX exposure explained.
You can also set a free rate alert for any pair and get an email when it reaches your level.