Helps businesses protect themselves against changing currency exchange rates
Currency hedging helps businesses protect themselves against fluctuations in the currency exchange rates. The goal of currency hedging is to mitigate the impact of currency movements on the value of assets or liabilities denominated in foreign currencies. There are different methods used in currency hedging.
Forward and Future contracts
Exchanging currencies at a future date at a predetermined price (that is, regardless of the exchange rate at the time of fulfilling the contract).
Forward and Future contracts are slightly different from each other. future contracts often require a 5 to 10% initial deposit (depending on the parties involved) and are traded on exchanges.
While forward contracts typically do not require any down payments and are traded over the counter (OTC).
The principal and interest amount in one currency is exchanged for the principal and interest in another currency with the principal amounts implying the exchange rates between two parties.
Two currencies are exchanged at a specified rate before a specific deadline. The contract gives the buyer the right to exchange the currencies. However, the buyer is not obliged to do so.
Hedging has its advantages and disadvantages. One advantage is that the business is protected against unfavorable exchange rates.
For example, a US company wants to buy 10000 Canadian dollars. So they enter into a Forward contract that allows them to exchange US dollars to Canadian dollars (sometime in the future) at a predetermined rate of 1 USD : 1.2 CAD.
That the US company will need about 8000 dollars in order to get 10,000 CAD, which means they have gained. But exchange rates fluctuates and at the time of exchange, USD to CAD exchange rate could go even higher to say 1 USD : 1.8 CAD.
This means that if the US company had not entered into a forward contract, they would be able to get the 10,000 Canadian dollars for just 5,500 US dollars. Which is even better than the predetermined rate.
At the same time, if the exchange rate should nose dive and Canadian dollars plummet against USD, then the US company would have to pay more US dollars for the same 10,000 Canadian dollars.
So businesses hedge currencies in order to avoid speculative scenarios like this.
But should the exchange rate be lower that the predetermined or agreed rate, then the business losses. This is usually the case with forward or future contracts.