Currency Hedging

Currency Hedging

According to dictionary.com, to hedge is “to minimize or protect against the loss of by counterbalancing one transaction, such as a bet, against another.” (www.dictionary.com) An international company uses currency hedging to protect against fluctuating foreign exchange rates. Currency hedging is important in managing risks by allowing a company to predetermine the profit it will make on a transaction. Currency hedging, if used correctly, can be beneficial to a company.

Currency hedging is the act of entering into a contract, today, with a foreign exchange company to exchange a foreign currency into US currency at a certain exchange rate on a specified date in the future. For instance, a US company enters into a contract with a company in Europe to sell a product; the contract amount is 3.0 million euros. When the current foreign exchange rate for euros to dollars was equal, the US company would make $3.0 million. To protect its profits, the US company would then negotiate a forward transaction with a foreign exchange bank to convert euros to dollars on the date payment is due from the other company. The foreign exchange bank will quote the US company an exchange rate for that date. When the US company converts the Euro payment to US dollars, the US company will receive the quoted exchange rate regardless of the current exchange rate.

Besides forward transactions, other currency hedging tools include spot contracts, window forwards, options, currency swaps, and non-deliverable forwards. A spot contract converts foreign currency into US dollars or US dollars into foreign currency at today’s interest rates. This form of currency hedging is usually used by individuals traveling overseas or to the US that need to convert their money into usable currency within the visiting country. “A window forward contract gives you a range of days (a "window" of time) on which to buy or sell the foreign currency. Window forwards are often used when there is uncertainty regarding the actual payment date.” (Currency Hedging Tools) An option contract guarantees a buyer “a worst-case exchange rate for the future purchase of one currency to another.” (Currency Hedging Tools) A buyer is not required to go through with the contract; therefore, it protects a buyer by giving him the option of exchanging currency during favorable exchange rates or backing out of the contract during unfavorable exchange rates. A currency swap lets a company to “simultaneously purchase and sell a given currency at a fixed exchange rate and then re-exchange those currencies at a future date.” (Currency Hedging Tools) A currency swap is useful to companies with constant recurring cash flows from and to another country. Non-deliverable forwards are “a way to hedge exposures in emerging market currencies where a conventional forward market does not exist or is restricted.” (Currency Hedging Tools) The difference between a forward transaction and a non-deliverable transaction is “a non-deliverable forward is settled in U.S. dollars and involves no physical exchange of foreign currencies at maturity.” (Currency Hedging Tools)

A company may use “currency-hedging strategies when it is unsure of what the market will do. A perfect hedge reduces your risk to nothing (except for the cost of the hedge).”