Hedge FX exposure using Forward or Loan - Which is Better?

Foreign currency exposure can be hedged in several ways. A typical example is a company that earns revenue in foreign currency and needs to decide on the most appropriate hedging technique. Two of the most basic—and, in theory, equivalent—approaches are:

1. Executing a forward contract to sell the foreign currency and buy the company’s functional currency.

2. Taking a loan in the foreign currency, converting it to the functional currency, and placing it in an interest-bearing deposit.
   
   

But are these alternatives truly economically equivalent?

To illustrate, consider a company whose functional currency is the U.S. dollar and which expects to receive revenue in euros in a given month. The company evaluates the profit/loss profile of both methods in terms of foreign exchange exposure.

Both strategies offer protection against appreciation of the dollar relative to the euro—but at what cost?

• The cost of the forward is reflected in the difference between the spot rate at the time of the transaction and the forward rate. This spread—commonly referred to as "forward points"—represents the interest rate differential between the base currency (dollar) and the quote currency (euro).
  
  

• The cost of the loan lies in the difference between the interest the company must pay on a euro loan and the interest it earns on a dollar deposit.
  
  

While both approaches reflect interest rate differentials between the two currencies, the underlying interest rates are not directly comparable in practice.

Forward points are typically derived from relatively low-risk interbank rates or market-based benchmarks used in institutional trading environments. By contrast, the company’s actual borrowing cost in euros—and the return it receives on a dollar deposit—are influenced by its specific credit risk and the spread banks charge between lending and deposit rates.

Moreover, taking a foreign currency loan uses up part of the company's credit lines, which could constrain its ability to secure future operational financing.

As a result, in most situations, a forward transaction is the more cost-effective and practical hedging tool. This remains true even when accounting for the collateral required for forward contracts, which is generally modest (often up to 10% of the contract value), and the associated interest cost, which aligns with the company's standard borrowing rate.

Is a Forward Always Better Than a Loan?

Although forward contracts are usually cheaper and more straightforward than the loan-and-deposit alternative, foreign currency credit may still play a useful role in a company’s financing strategy.

If the company already needs bank credit—such as to finance working capital—then the cost of that credit is essentially a sunk cost. In that case, it may be worthwhile to diversify the credit mix and include foreign currency loans, particularly in the currency in which the company expects net inflows. The key challenge is to select the right mix of currencies and maturities to match and hedge future cash flows effectively.

That said, companies should avoid overhedging. For example, taking out a long-term foreign currency loan that exceeds the company’s annual exposure is akin to entering into a string of forward contracts that extend beyond a year.

In practice, most companies are cautious about entering long-term forward contracts for large exposure amounts. This hesitation stems from concerns about losing pricing flexibility compared to competitors and from potential earnings volatility due to changes in the fair value of derivatives.

For these reasons, using foreign currency loans as a hedging instrument requires careful consideration, just like any other derivative or credit-based tool.

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