Currency Hedging: Currency Hedging Is The Use of Financial Instruments, Called Derivative Contracts, To

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.
What is Foreign Currency Hedging?
Foreign currency hedging involves the purchase of hedging instruments to offset the
risk posed by specific foreign exchange positions. Hedging is accomplished by
purchasing an offsetting currency exposure. For example, if a company has a
liability to deliver 1 million euros in six months, it can hedge this risk by entering
into a contract to purchase 1 million euros on the same date, so that it can buy and
sell in the same currency on the same date. We note below several ways to engage in
foreign currency hedging.
Loan Denominated in a Foreign Currency
When a company is at risk of recording a loss from the translation of assets and
liabilities into its home currency, it can hedge the risk by obtaining a loan
denominated in the functional currency in which the assets and liabilities are
recorded. The effect of this hedge is to neutralize any loss on translation of the
subsidiary’s net assets with a gain on translation of the loan, or vice versa.
Forward Contract
A forward contract is an agreement under which a business agrees to buy a certain

amount of foreign currency on a specific future date, and at a predetermined
exchange rate. By entering into a forward contract, a company can ensure that a
definite future liability can be settled at a specific exchange rate. Since this is a
custom contract, it can be set to exactly hedge the underlying currency position.
Futures Contract
A futures contract is similar in concept to a forward contract, in that a business can

enter into a contract to buy or sell currency at a specific price on a future date. The
difference is that futures contracts are traded on an exchange, so these contracts are
for standard amounts and durations. Because only standard amounts are traded, the
resulting hedge may only cover a portion of the underlying currency position.
Currency Option
An option gives its owner the right, but not the obligation, to buy or sell an asset at a
certain price (known as the strike price), either on or before a specific date. This is a
useful option when a business needs to acquire foreign currency on a future date
(usually to pay an invoice), and the currency is subject to some degree of variability.
Cylinder Option
Two options can be combined to create a cylinder option. One option is priced above
the current spot price of the target currency, while the other option is priced below
the spot price. The gain from exercising one option is used to partially offset the cost
of the other option, thereby reducing the overall cost of the hedge.
Benchmark Hedge Ratio
One should decide what proportion of risk exposure to hedge, such as 100% of the
booked exposure or 50% of the forecasted exposure. This gradually declining
benchmark hedge ratio for forecasted periods is justifiable on the assumption that
the level of forecast accuracy declines over time, so at least hedge against the
minimum amount of exposure that is likely to occur. A high-confidence currency
forecast with little expected volatility should be matched with a higher benchmark
hedge ratio, while a questionable forecast might justify a much lower ratio.

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Currency Hedging

Loan Denominated in a Foreign Currency

A forward contract is an agreement under which a business agrees to buy a certain

A futures contract is similar in concept to a forward contract, in that a business can

Benchmark Hedge Ratio

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