What is Currency Hedging? - Definition, Example & Risk

Instructor: Shelumiel Ryan Abapo

Shelu is a Certified Public Accountant, SAP Business One Consultant, University Professor handling Taxation, Financial Accounting, Cost Accounting and Basic Accounting

After this lesson, you will be able to understand the nature and purpose of hedging, identify the common derivative contracts and recognize the financial risks related to derivatives.

What Is Currency Hedging?

Have you ever traveled to a foreign country? If you have, you may remember dealing with the exchange rate, which tells you how much your dollar is worth in euros, pesos, yen, or whatever the foreign currency is.

Guess what? Large companies deal with this every day on a massive scale. A change in the exchange rate might have altered how many souvenirs you could buy, but to large companies, a change in the exchange rate can cause catastrophic losses. How can companies handle such huge financial risk?

Currency hedging is the use of financial instruments, called derivative contracts, to manage financial risk. It involves the designation of one or more financial instruments as a buffer for potential loss.

In hedging, the change in the fair value or cash flows of the derivative will offset, in whole or in part, the change in fair value or cash flows of a hedged item.

Imagine running a company in the United States, say MM Corporation; it has a loan of €50,000 with French Bank. Naturally, such a loan is denominated in the French currency, the euro of course.

Hence, the company is subject to the risk of fluctuating exchange rate between two different currencies.

As part of MM management, you know that when the dollar devalues against the euro, the company will have to pay more in dollars to settle the obligation. On the contrary, should the euro devalue against the dollar, the company will need a lesser amount in terms of US dollars.

To manage this risk of paying more upon maturity date, you entered into a foreign currency forward contract with a third party speculator.

On the contract date, the forward contract was set at the current exchange rate. The exchange rate was $1 to €0.93. This means that to settle the loan amounting to €50,000, MM Corporation's payment is pegged at €0.93, or $53,764, regardless of the dollar to euro exchange rate on maturity date.

If on the maturity date, the dollar devalues against the euro and the exchange rate is at $1 to €0.90, MM will need more US dollars - $55,556 - to settle the obligation; however, since MM Corporation entered into a foreign currency forward contract, the eventual net cash outflow by MM will only be $53,764, the amount originally pegged.

Of course, MM will have to pay French Bank the total amount of $55,556, but the difference of $1,792 will be received by MM from the third party speculator.

Conversely, if the euro devalues against the dollar and the exchange rate will be $1 to €1.02, the eventual net cash outflow of MM will still be $53,764. MM will have to pay French Bank $49,020 and MM will have to pay the third party speculator the amount of $4,744.

A hedged item is an asset, liability, firm commitment or a net investment in a foreign operation, that exposes the company to the risk of changes in fair value or future cash flows.

In our illustration, the hedged item is actually the loan denominated in foreign currency. The derivative contract, or the hedging instrument, is the foreign currency forward contract, and the related risk is the foreign currency risk.

In a hedging contract, there are two parties: the company and the third party speculator, usually a bank.

Again, the purpose of hedging is to manage financial risk.

This risk management strategy will limit or offset the probability of loss due to the fluctuation in the prices of commodities, currencies or securities. In the process, there is transfer of risk without necessarily buying insurance policies.

Financial Risk

Financial risk may be categorized into four types:

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