FX hedging is the practice of fixing or limiting the exchange rate on a future foreign currency payment or receipt, so that a movement in the market does not change what the transaction is worth in pounds. For a finance director, it is a way to protect budgeted margins, cash flow and reported profit from currency swings the business cannot control. This guide explains, in plain language, what FX hedging is, why finance teams use it, the instruments available, and the practical and accounting points to weigh before putting a programme in place. Medlock & Thames is a currency broker, so this is general information to inform a conversation with your board and advisers, not advice on what your business should do.
What is FX hedging?
FX hedging means using a currency contract to set, in advance, the rate at which a future foreign currency amount will be exchanged, or to cap how far that rate can move against you. Currency risk, also called FX risk or exchange rate risk, is the chance that a change in the exchange rate alters the value of a payment, a receipt or a balance held in another currency. A business that sells in euros but reports in pounds carries that risk on every invoice until the euros are converted. Hedging does not predict the market or aim to win on the rate. It removes, or narrows, the uncertainty, so that a figure agreed today is still the figure that lands when the cash moves.
Why do finance directors hedge currency risk?
The core reason is certainty. A finance director plans margins, budgets and forecasts in pounds, yet the cash often arrives or leaves in another currency weeks or months later. The pound regularly moves by several per cent over a few months, and the Bank of England publishes the daily spot rates that show how often sterling shifts on interest rate decisions, inflation data and political news. A move of that size can turn a profitable contract into a marginal one, or push a project over budget, even though nothing about the commercial deal has changed. Hedging lets a finance team commit to a price, protect a forecast margin, and give the board predictable numbers, rather than leaving the outcome to the market on settlement day. For businesses with debt covenants or earnings guidance, reducing that volatility can matter as much as the rate itself.
What types of currency risk affect a business?
Currency risk shows up in three main forms, and a hedging programme usually starts by identifying which ones apply.
Transaction risk is the exposure on a specific payment or receipt, whether already committed, such as a signed supplier contract, or highly likely, such as forecast seasonal sales. It is the most common focus of hedging because the cash flow and its timing can be estimated.
Translation risk arises when a group with foreign operations consolidates the results and balance sheets of those operations into pounds for reporting. The underlying cash may never be converted, but the reported figures move with the exchange rate at the period end.
Economic risk, sometimes called competitive risk, is the longer term effect of currency movements on a company's costs, pricing and competitive position, for example when a sustained strengthening of sterling makes an exporter's goods dearer abroad. It is the hardest to quantify and is usually managed through commercial decisions rather than a single contract.
What instruments are used to hedge FX risk?
Several currency tools are available, and they are often combined. The right mix depends on the exposure, the certainty of the cash flows and the policy the business has set.
A spot contract converts currency at today's rate for settlement within a day or two. It is simple, but it offers no protection for payments due in the future, so it suits immediate conversions rather than planning ahead.
A forward contract fixes today's rate for settlement on a set future date, usually up to twelve months ahead and sometimes longer, in exchange for a small deposit. It is the most widely used hedging tool because it turns an uncertain future cost into a known one. We explain the mechanics, with a worked example, in how a forward contract works.
A flexible or window forward works in the same way but lets the business draw down the currency across a range of dates rather than on a single day, which helps when the exact timing of a payment is not yet fixed.
A currency option gives the right, but not the obligation, to exchange at an agreed rate, in return for a premium paid upfront. It protects against an adverse move while leaving room to benefit if the rate moves in the business's favour. Because it behaves differently from a forward and carries a cost, we compare the two in detail in forward contracts and currency options.
Market orders can also be used to target a rate or to set a protective floor, automatically executing if the market reaches a chosen level. These tools are not mutually exclusive, and many businesses use forwards for committed exposures alongside other tools for forecast or smaller flows.
How much of an exposure do businesses hedge?
There is no single answer, and the proportion a business chooses to hedge, often called the hedge ratio, is a policy decision rather than a formula. Some businesses fix a large share of committed exposures and a smaller share of forecast ones, then add to the hedge as forecasts firm up, an approach sometimes described as layering or rolling. Others hedge only specific large contracts. The right level depends on how certain the cash flows are, how much volatility the business can absorb, and the view the board takes on risk. A currency broker can model the exposure and the contract options, but the decision on how much to hedge sits with the business and, where relevant, its auditors and advisers.
What is a currency hedging policy?
A hedging policy is a short written framework, owned by the board or finance committee, that sets out how the business manages currency risk. It typically records the objective, for example protecting budgeted margin rather than speculating on the rate; which exposures are hedged and from what point; which instruments are permitted; the maximum tenor and hedge ratios allowed; and who is authorised to agree contracts. A clear policy keeps hedging disciplined, makes it easier to explain to auditors and lenders, and stops decisions resting on a single person's view of where the market is heading. It is also the document that distinguishes hedging, which is risk management, from speculation, which most policies expressly rule out.
How does hedging affect the accounts?
Currency contracts are derivatives, and accounting standards generally require them to be measured at fair value, with changes in that value flowing through the accounts. Left unmanaged, that can introduce timing mismatches, where the gain or loss on a hedge lands in a different period from the transaction it protects. Hedge accounting is the optional set of rules that lets a business align the two, reducing volatility in reported profit. Companies reporting under UK adopted IFRS apply IFRS 9, while many private companies apply Section 12 of FRS 102 under UK GAAP, as set by the Financial Reporting Council. Because the detail matters and the documentation must be in place from the start, we cover it in a dedicated guide: IFRS 9 hedge accounting explained.
According to Medlock & Thames
In our experience, most finance teams contact us only after an adverse move has already compressed a margin, often once the rate has shifted three to five per cent against a contract that was priced months earlier. The businesses that find hedging most useful are those that treat it as budget protection, set at the moment a price is agreed, rather than as a reaction once the market has already moved. The tool matters far less than the timing of the decision.
Frequently asked questions
Is FX hedging the same as speculation?
No. Hedging is used to protect the value of a genuine commercial cash flow, such as a supplier payment or export receipt, and is settled by delivering the currency. Speculation aims to profit from currency movements. Most hedging policies exclude speculation explicitly.
Does hedging guarantee a better exchange rate?
No. Hedging provides certainty, not the best possible rate. If the market later moves in your favour, a fixed forward means you do not benefit from that move. The aim is a known outcome, not beating the market on the day.
Does a business need to be large to hedge currency risk?
No. Forward contracts and other tools are available to smaller businesses as well as large corporates. What matters is having a foreign currency exposure worth protecting and a clear view of the cash flows involved.
How far ahead can a business hedge?
Forward contracts are commonly available up to twelve months ahead, and sometimes longer, which covers most budgeting and contract cycles. The available tenor depends on the currency pair and the provider.
Is Medlock & Thames giving financial advice?
No. Medlock & Thames is a currency broker. We provide information and execute transactions through FCA authorised partners that safeguard client money, and we do not provide regulated investment advice. You can read how that works in our regulation and compliance guide.
Related articles
This guide is the hub of our FX Hedging and Treasury series. For the accounting detail, read IFRS 9 hedge accounting explained. To compare the two main instruments, see forward contracts and currency options. For the mechanics of fixing a rate, read how a forward contract works. To speak to a dealer about a corporate exposure, visit corporate currency, and for finance options see business finance.
For the adviser and funding views of the same risk, see the accountant's guide to FX risk for SME clients and business finance and currency.
