Currency Hedging
According to dictionary.com, to hedge is "to minimize or protect against the loss of by counterbalancing one transaction, such as a bet, against another." (www.dictionary.com) An international company uses currency hedging to protect against fluctuating foreign exchange rates. Currency hedging is important in managing risks by allowing a company to predetermine the profit it will make on a transaction. Currency hedging, if used correctly, can be beneficial to a company.
Currency hedging is the act of entering into a contract, today, with a foreign exchange company to exchange a foreign currency into US currency at a certain exchange rate on a specified date in the future. For instance, a US company enters into a contract with a company in Europe to sell a product; the contract amount is 3.0 million euros. When the current foreign exchange rate for euros to dollars was equal, the US company would make $3.0 million. To protect its profits, the US company would then negotiate a forward transaction with a foreign exchange bank to convert euros to dollars on the date payment is due from the other company. The foreign exchange bank will quote the US company an exchange rate for that date. When the US company converts the Euro payment to US dollars, the US company will receive the quoted exchange rate regardless of the current exchange rate.
Besides forward transactions, other currency hedging tools include spot contracts, window forwards, options, currency swaps, and non-deliverable forwards. A spot contract converts foreign currency into US dollars or US dollars into foreign currency at today's interest rates. This form of currency hedging is usually used by individuals traveling overseas or to the US that need to convert their money into usable cu ...