How to hedge foreign exchange risk
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Foreign exchange, or F/X, contracts always specify a pair of currencies in the form of a fraction. For example, USD/JPY is the currency pair in which you buy dollars and sell Japanese yen. You always buy the numerator, or base currency, and sell the denominator, or quote currency. The base currency is always set to one unit. In this example, the currency pair designates how many yen you could buy for $1. You buy and sell currency pairs through online foreign exchange brokers. Buying a USD/JPY contract is the same as selling a JPY/USD contract.
F/X contacts come in a variety of sizes, but the CME Futures Exchange sizes the standard yen futures contract at 12.5 million yen. An exchange rate of 100 yen to the dollar would set a standard contract's value at $125,000. To mitigate trading risk, you sell contracts in which the base currency is that of your trading partner and the quote currency is U.S. dollars, for example JPY/USD. Selling this contract would protect a U.S. company should the dollar strengthen relative to the yen between the time the company strikes a deal and the time it delivers the product.
Imagine a company sells $250,000 worth of merchandise to a Japanese company for delivery in three weeks. The contract calls for payment of 25 million yen to the seller on the delivery date. Suppose during the interim that the dollar strengthens
enough to purchase 101 yen. The value in dollars of the 25 million yen payment is then only worth (25,000,000/101), or $247,525, a loss in value of $2,475. By selling two JPY/USD F/X contracts at the time of the sale, the company will receive an F/X profit that exactly offsets the currency loss on the merchandise sale.
Currency swaps are contracts in which each party periodically exchanges cash flows based upon exchange rate changes to a notional, or imaginary, amount of currency. The parties don't exchange the notional amount, just the changes in value. Both swaps and F/X contracts can gain or lose value, but when used as a hedge, the gain in the underlying deal mitigates part or all of an F/X loss. Buying currency options gives you the right, but not the obligation, to purchase or sell F/X contracts at a set exchange rate. The most you can lose is the relatively low price of the option.
Some U.S.-based corporations may have enough market clout to forge foreign contracts denominated in U.S. dollars rather than in the buyer's local currency. By taking this route, the U.S. company transfers currency risk to the buyer. Of course, should the dollar weaken during the contract period, the foreign buyer will receive the benefit, but at least the seller is immune to foreign currency losses. The foreign company might add a fee or withhold a discount when it agrees to transact in U.S. dollars.Source: ehow.com