As a business owner in the United Kingdom, you are likely to face many risks that could have severe consequences for your company. These risks can come from several sources, including volatile markets, currency fluctuations, and interest rate changes.
Fortunately, there are many ways to mitigate these risks and protect your business. Read on for the most common hedging strategies used in the UK.
A forward contract is an agreement between two parties to buy or sell an asset at a specified price at a future date. Forward contracts are often used to hedge against currency risk, as they allow businesses to lock in exchange rates for future transactions.
For example, imagine that you are a UK-based company that exports goods to the United States. You know that you will need to convert GBP to USD to pay for your imports, but you are worried about the GBP/USD exchange rate changing between now and when you need to make the payment.
You could enter into a forward contract with a currency broker to exchange GBP for USD at the current exchange rate, and it would guarantee the exchange rate for your transaction, regardless of what happens in the market.
A currency option is a contract that gives the holder the right, but not the duty, to buy or sell a set number of currencies at a specified price on or before a specific date. Like forward contracts, currency options are often hedged against exchange rate risk.
However, there are some critical differences between currency options and forward contracts. First, with a currency option, you are not obligated to make the trade if you do not want to, and it means that you only have to make the trade if it is advantageous. Second, currency options typically give you the right to buy or sell a more significant amount of currency than you would with a forward contract. It can be beneficial if the market moves in your favour.
Interest rate swaps
An interest rate swap is an agreement between two parties to exchange one stream of future interest payments for another. Swaps are commonly used to hedge against changes in interest rates.
For example, imagine that you have a loan with an interest rate of 5%. You are worried that interest rates will rise in the future, which would increase your interest payments. To hedge against this risk, you could enter into an interest rate swap with another party. Under this agreement, you would agree to exchange your 5% interest payments for a stream of payments based on the present market interest rate. It will protect you from paying higher interest payments if rates do rise.
An equity option is a contract that gives the holder the right, but not the obligation, to buy or sell a specified number of shares at a specified price on or before a specific date. Investors often use equity options to hedge against a stock price decline.
For example, imagine that you own shares in Company XYZ. You are worried that the stock price may fall in the future, so you decide to buy a put option. It will give you the right to sell your shares at a specified cost on or before a set date (the expiration date). If the stock price falls below the strike price, you can exercise your option and sell your shares for more than they are currently worth.
A commodity future is a contract to buy or sell a specified amount of a commodity at a set cost on or before a specific date. Businesses often use commodity futures to hedge against changes in commodity prices.
Imagine that you are a farmer who produces wheat. You are worried that the price of wheat may fall in the future, so you decide to sell a wheat futures contract. This contract obligates you to sell a specified amount of wheat at a specified price on or before a specific date. If the price of wheat does fall below the contract price, you will still be able to sell your wheat for the higher price. It protects you from losses if the price of wheat falls.
The bottom line
At the end of the day, there are many common hedging strategies to employ to protect your business. When it comes down to it, these hedging strategies can also be employed in regular forex trading for business owners interested in earning a bit more passive income, as they run on the same principles. Follow this link to trade forex online with a reputable and UK-licensed broker to get started.
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