How UK SMEs are using derivatives to manage currency risk
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How UK SMEs are using derivatives to hedge currency risk and protect margins
Extreme movements in exchange rates have pushed many UK small and medium-sized businesses to take a closer look at how they handle overseas payments and sales. This article explores how UK SMEs are using derivatives to hedge currency risk and protect their profit margins.
Why UK SMEs need to hedge against currency risk
A recent survey of UK SMEs by Bibby Financial Services found that 54% of businesses that do not protect against currency swings reported being negatively impacted by volatile exchange rates in the past year. Those affected lost more than £53,000 because of currency fluctuations. Smaller firms with fewer than 10 employees were hit even harder, with 72% reporting losses.
Because of these losses, hedging rates among UK companies have risen for three years in a row. They reached 78% in 2025, up from 76% in 2024 and 70% in 2023. Among firms that do not currently hedge, 68% are now thinking about doing so because of market conditions, according to a MillTechFX survey reported by Reuters. UK SMEs are now using either one derivative or a combination of several.
What are derivatives?
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Derivatives are contracts made between two or more parties. They can be traded on a formal exchange, or directly between parties in what is called the over-the-counter (OTC) market. Derivatives serve two main purposes. The first is speculation, where traders use derivatives to bet on currency movements in hopes of making a profit. They do not need to own the actual currency to do this.
Contracts for difference (CFDs) are a common example of derivatives used for speculation. With CFD trading, investors can profit from rising or falling currency prices without actually buying or selling the currency itself.
The second purpose is hedging, where companies use derivatives to protect themselves against bad currency movements. UK SMEs commonly use four types of derivatives for currency hedging.
1. Forward Contracts
Forward contracts are OTC agreements between a company and another party. They agree to exchange two currencies at a set date in the future. Businesses use forward contracts to lock in good exchange rates for future deals. They work well for exporters, importers, and other companies that trade abroad and know when they will receive or pay foreign currency. For example, a UK exporter expects to receive $500,000 in three months. The company enters into a forward contract to sell dollars and buy pounds at a fixed rate. This locks in the exchange rate and ensures the business knows exactly how many pounds it will receive when the payment arrives.
Pros
- Forward contracts protect against bad currency movements.
- The terms can be adjusted to fit the company’s needs, including the amount, date, and currency.
Cons
- The company must complete the contract even if the market rate becomes better later.
- Some forward contracts need a margin deposit, which ties up cash.
2. Futures contracts
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Futures contracts work much like forward contracts. The main difference is that futures have standard terms and trade through an exchange rather than directly between parties. Futures suit companies that want to avoid the risk of the other party failing to pay. They also work well for businesses dealing with smaller amounts. Take a UK company with regular euro payments buys several euro futures contracts to protect against pound/euro rate changes over the next quarter. Like a forward contract, this locks in a known exchange rate for planned transactions in a foreign currency.
Pros
- Prices are set on regulated exchanges, so everything is clear and open.
- Futures contracts are easier to buy and sell than OTC contracts like forwards.
Cons
- Contract sizes and end dates are fixed, so there is little room to adjust terms.
- Futures need an upfront margin payment plus daily maintenance margins.
3. Options contracts
Options give the buyer the right to exchange currency at a set rate by a certain date. However, the buyer does not have to use this right. There are two types of options:
- Call Options: The right to buy a currency.
- Put Options: The right to sell a currency.
Options suit companies that want protection against bad exchange rates while keeping the chance to benefit if rates move in their favour. Suppose a UK importer buys a call option to purchase euros at £0.85 per euro. This keeps costs stable even if the pound weakens. If the exchange rate at expiry is £0.84 per euro, the company lets the option expire and buys euros at the cheaper market rate. However, if the rate moves to £0.87 per euro, the company uses the option and receives compensation for the difference. This results in an effective rate of £0.85 per euro.
Pros
- Options are very flexible. The amount, rate, and end date can all be adjusted.
- Options offer upside potential. If the market rate is better when the option expires, the company can simply let the option expire and use the market rate instead.
Cons
- Options require an upfront premium payment. This cost can be high depending on market conditions and the protection level chosen.
4. Currency Swaps
Currency swaps are contracts where two parties exchange cash flows in one currency for cash flows in another currency. Large companies with overseas operations use currency swaps to manage long term exposure. Swaps also let companies benefit from better borrowing conditions in foreign markets. To illustrate, a UK company with operations in the United States enters into a currency swap to convert its dollar debt into pounds. This reduces exposure to exchange rate changes. The company can borrow in dollars when rates are good while keeping its overall funding costs stable in pounds.
Pros
- Swaps help businesses get better borrowing terms in foreign currencies.
- They reduce long term currency risk.
Cons
- Swaps need expert knowledge to set up properly. They can be complex.
- Transaction costs are high.
Looking ahead
Industry experts predict that currency hedging will become standard practice for UK businesses trading internationally within the next two years. This trend will also accelerate as younger, more financially literate entrepreneurs take the reins at small and medium sized firms across the country.