Tools for Hedging Foreign Exchange Risk

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  • 0:04 Hedging Risks
  • 1:04 Forward Contracts
  • 1:41 Futures Contracts
  • 2:28 Debt Operations
  • 3:19 Swap Contract & Options
  • 5:02 Lesson Summary
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Lesson Transcript
Instructor: David Juliao

David has a bachelor's degree in architecture, has done research in architecture, arts and design and has worked in the field for several years.

This lesson explores five different tools for hedging foreign exchange risk. Learn about forwards, futures, debt, swaps, and options, and examine the features and possibilities each one offers for reducing risks in currency operations.

Hedging Risks

If you've traveled abroad, you probably noticed that the value of your dollars changed daily and things became more expensive for you, or cheaper if you were lucky. Similarly, you might have noticed that the price of many imported goods changes every month. This happens because of fluctuations in the currency exchange rate.

The foreign exchange market includes all the different transactions of currency exchange. It consists of selling domestic currency to buy foreign money at a certain value or rate, usually defined by supply and demand.

Eventually, movements in the exchange rate are a risk for investors and businesses with international operations. Therefore, they adopt strategies to minimize the impact of eventual adverse movements. This is known as hedging, and it involves using financial instruments to increase protection against currency fluctuations. Hedging makes transactions, cash flows, and cost structures more stable and predictable. The different tools for hedging against foreign exchange risk usually involve contracts for exchanging currency at a fixed rate at some point in the future.

Forward Contracts

Forward contracts, or forwards, specify an amount, exchange rate, and date for a currency exchange between two parties. Forwards allow parties to close deals and plan at current rates. They have practically no cost; however, there is always the risk of one party failing to comply.

Imagine a Chinese company is selling computers to an American buyer and will ship monthly for a year. They sign a forward stating that the buyer will pay at the end of the year at today's exchange rate. If the exchange rate changes, the contract guarantees that the buyer will still spend the same amount of dollars and the company will still receive the same amount of yuan.

Futures Contracts

Futures contracts, or futures, are financial instruments with conditions for a currency exchange, including the amount, rate, and expiry date. They are available in the market and can be traded like other financial assets. Futures eliminate the non-compliance risk of forwards, so they are common when there are credit risks. However, futures are not customized and are usually available only in major currencies.

By selling futures, investors might hedge devaluations. By buying futures, the hedge appreciates. For example, a U.S. company will receive 25 million British pounds in three months, so the company sells futures for delivery in 90 days. If the pound depreciates against the dollar, the expected amount is protected. However, if the pound appreciates, the company won't make any profit from the favorable exchange rate.

Debt Operations

Debt operations involve borrowing foreign currency. An investor borrows currency in the amount they expect to receive in the future. Then they exchange it into local currency and deposit it, hedging exchange rate risks. When the investor receives foreign currency, they use it to pay the debt. However, local interest might not be enough to pay the loan's interest, so this can sometimes be an expensive method.

Say a Mexican firm expects a payment of 150 million U.S. dollars, so they borrow 150 million U.S. dollars from an American bank and immediately exchange them at 12.5 pesos per U.S. dollar. They get 1,875 million pesos and deposit the money in a Mexican account. When they receive the payment, they pay the American bank. That day, the exchange rate was 11.5 per U.S. dollar, so they saved 50 million pesos.

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