Hedging Foreign Currency Related Risk; FX Risk; Foreign Exchange Rate Risk

Companies that increase the amount of business they do with foreign customers often increase their susceptibility to changes in foreign exchange rates. As international trade becomes a larger part of a company's total sales, that company must decision what do to about the additional foreign exchange exposure and risk. Companies involved in international trade are using foreign currency hedging more frequently as a way to control the potentially significant losses that can result from currency exchange exposure. To minimize or manage the risk, companies enter into contracts to buy foreign currency at a specified rate. This allows the companies to minimize the uncertainty relating to their profits on a sale being negatively impacted by unfavorable changes in foreign exchange rates.

There are actually a dizzying array of ways that trade creditors can hedge against unfavorable changes in the value of foreign currency exchange rates (relative to the U.S. dollar) when they are going to accept payment in currency other than U.S. dollars. Among the more exotic of these devices are:

• Call or put options allow the buyer of the option to purchase or sell a currency at a fixed rate without the obligation to do so. The buyer pays a premium for that privilege. In exchange for a premium paid at the beginning of the transaction, a currency option gives the holder the right but not the duty to buy or sell a currency at a designated price over a specific period of time, which ends at the expiration date of the option. Options can be either call options, which give the option holder, in return for paying a premium, the right to buy from the grantor of the option at the strike price, or put options which give the option holder, in return for paying a premium, the right to sell to the grantor of the option at the strike price. 
• Forward contract. A forward contract involves the outright purchase or sale of a foreign currency for a date in the future at a predetermined price. 
• An option straddle. This strategy involves purchasing both put and call options. The trader who buys an option straddle will make money provided that the size of the movement in value of the foreign currency is sufficient to cover the cost of the two premiums paid. Buyers of foreign currency straddles expect (hope for) large price movements to occur, while sellers of put and call options expect (hope for) foreign exchange rates not to move outside of a relatively narrow range.

© 2011 by Michael C. Dennis.  All Rights Reserved