Hedge Forex Currency Risk
When converting one currency to another in order to complete an international business transaction a company will find that foreign currency rates vary over time. Thus there is foreign currency risk in any purchase of a product or service from a country that requires payment in a currency different from that of the paying company. Many who must pay in such situations seek to hedge Forex currency risk. There are three ways to hedge Forex currency risk. Pay for the product or service immediately after signing the contract and hopefully get a discount for pre-paying. Buy futures on the currency required to make payment. Buy call options on the currency involved. Each way to hedge Forex currency risk has its own advantages and disadvantages.
Pay Up Front to Hedge Forex Currency Risk
If the time it takes to receive a product or service after paying is fairly short it may simply make sense to pay up front. The risk, of course, is that the company will not deliver the product in question. An alternative would be to buy the currency involved with the company’s own currency and hold it until delivery. However, if payment is for something like building a ship or installing complex technical equipment a company may need to generate cash along the way in order to make payment and will not want to draw down cash reserves in the process.
Buy Futures to Hedge Forex Currency Risk
A company will use its own currency to purchase the necessary currency at a future date. The company will obligate itself to purchase the currency in question. This works out fine if the price of the futures contract is attractive. Even if the price of the foreign currency rises unexpectedly the company will only need to pay the price specified by the futures contract. However, if the company’s own currency rises substantially, it will be obligated to pay more than the current price of the foreign currency when it pays for its futures contract.
Forex Options as a Way to Hedge Forex Currency Risk
Trading options on foreign currencies has two benefits. One is the leverage that options trading provides...