How does foreign exchange risk hedging work?
Foreign exchange risk hedging: importance and risk for Mexican Small and Medium-Sized Enterprises that import inputs in dollars

You have a company that makes furniture, your customers are local and, therefore, your sales are in Mexican pesos. You have a debt of $ 100,000 USD that you have to pay in two months for raw materials that you imported on credit.

Which would you prefer if the exchange rate were 19.30 Mexican pesos to the dollar today: owing $ 100,000 USD or owing $ 1'930,000 Mexican pesos?

The answer seems very logical! You have a certain profit margin, and your business is to make furniture, not to try to beat the market by hoping to buy cheaper dollars in two months when you have to pay your debt. Doing this is called speculating, something that many businesspeople do without realizing it, losing focus of what their business really is – making furniture, in this case.

Ironically, using derivatives to cover risks is reputed to be risky, but so is having your cashflow in pesos, debts in another currency and not using any hedging, or insurance. How would a devaluation, like those that Mexico has experienced in the past, of, for example, 50% impact you? Let us remember that many companies have gone bankrupt exactly for this reason.

How does foreign exchange risk hedging work?

When risks are covered through regulated exchanges, such as the Chicago Mercantile Exchange or Mexder, through futures contracts, the exchange only compensates.

This means that if the purchase price agreed upon is 19.30 pesos per dollar and the exchange rate goes up to 20.30 pesos per dollar, the exchange will not sell the dollars at $ 19.30, but rather compensate the purchaser with $ 1.00 peso per dollar covered to buy the dollars wherever the client prefers, obtaining the same final cost for the person who is covered.

If the exchange rate were to fall, for example, to $ 18.30, then the client would buy dollars closer to this price would where he/she prefers, and the exchange takes away a peso, giving the same result, an approximate cost of $ 19.30 pesos.

Why can it be risky to trade in derivatives?

When people buy derivatives through an exchange, the exchange only compensates, that is, the exchange does not care if the purchaser really has a furniture factory, or how much he/she really needs to be protected. It is understood that most market participants simply speculate; thus, if you made a trade to hedge 100,000 dollars, and the dollar increases one peso in price, the exchange will compensate you with 100,000 pesos.

This is where greed sometimes plays a role and derivatives are not used for the purpose for which they were created. People begin to speculate, hedging twice or three times, or even more than necessary because they are convinced that the price will go up. This is why it is very important to implement adequate coverage policies, where only what is needed is hedged.

Which exchanges trade in Mexican peso futures?

We can find contracts listed on both the Mexder and the Chicago Mercantile Exchange. In the case of the CME Group, an average of 45,000 contracts are moved daily, amounting to approximately $ 22'500,000,000 pesos in the nominal value of the contracts.

In the Mexder, each contract is for $ 10,000 dollars, while in the CME each contract hedges $ 500,000 pesos (approximately $ 26,000 dollars) and requires a margin of guarantee of $ 1,400 dollars.

In conclusion, hedging risks in a regulated market offers different advantages. First of all, transparency, since the derivative is bought and sold at the price that is directly quoted on the exchange; and secondly, the fact that it is compensation, offering the flexibility of liquidating the contracts on the date that the dollars need to be paid and of buying them when it is most convenient.