Currency hedging is used by companies to reduce their foreign exchange exposure. If a manufacturer with overheads and costs to be paid in euros takes on an order that will be paid in dollars, the company has an exposure to the euro-dollar rate and therefore uncertainty in its future cashflows. There are several ways of hedging this currency risk.
The company can buy euros immediately using dollars. This requires an initial cash outlay and ties up cash until the company receives payment in dollars. If the currency conversion rate moves in a favourable direction for the company (ie, the dollar strengthens) the company will have lost out by buying euros immediately. But if the dollar falls further, the company will have saved money.
The company could enter into a forward agreement with a fixed conversion rate. No money is needed upfront and no cash is tied up. But the company could still end up paying more for its euros if the dollar strengthens as it would be obliged to buy its euros at a predetermined rate.
The company could buy an option giving it the right, but not the obligation, to buy euros at a predetermined rate. If the spot rate moves in a favourable direction for the company, there is no need to use the option. If the dollar moves in an unfavourable direction the company can exercise the option, buying euros at a pre-determined price.
Source: Flight International
