Many businesses of all sizes often
import items from foreign countries and as such are required to deal
with many different currencies on a regular basis. However, when holding
currencies it is important that they too hedge their currency exposure.
Hedging may sound complicated but all it refers to is methods of trying
to reduce your exposure to the various risks outlined in the other articles
in this section. As the currency market is as volatile and unpredictable
as ever, many companies and individuals are looking to hedge their currency
portfolio, corporation or foreign assets from the risk of fluctuations.
The type of currency hedging strategy used, will depend on the expectations
and needs of the importer. A greater desire for flexibility may propel
the importer to opt for swaps and options. In case of forwards and futures,
familiarity with the counter party to the contract would determine the
One option for an importer is to
enter into a forward contract to buy a fixed amount of a currency for
a given amount of GBP, USD etc. A currency forward contract is an agreement
to purchase or sell the currency at a pre-agreed price at a set date
in future, regardless of the price of the asset in the spot market.
Assets are traded at the currently prevailing prices in the spot market.
The two parties to a forward contract are the long and the short. This
arrangement helps eliminate uncertainty, in the amount of payment that
has to be made for imports, on account of fluctuating foreign currency.
The importer can take a long position in the forward contract and thus
Similar to these contracts, a futures
contract was designed in order to overcome the disadvantages of a forward
contract. One of the disadvantages, of a forward contract, is that the
contract is not standardised. Essentially, the entire payment has to
be made or received, in one go, at some point of time in future so the
chances of default are high. Thus a futures contract that allows the
importer to pay a set price for the Euros that would be purchased at
a later date, can help him hedge foreign exchange risks.
Options, as the name implies, allows
the importer the option of purchasing the asset or currency at a set
price, on or before the expiry of the contract. Forwards and futures
give the importer the opportunity to get rid of the risk of having to
purchase Euros by exchanging more Dollars on account of the depreciating
dollar. However, if the dollar appreciates, the importer will stand
to lose. This is because he would be tied into buying Euros by exchanging
GBP or Dollars or whatever currency at the set rate and would be unable
to exchange dollars for Euros at the prevailing favorable exchange rate.
European options, allow the importer to buy the currency only on the
expiry of the contract.
The final option for businesses looking
to import is currency swaps. The importer can enter into a currency
swap with a European trader who needs Dollars. In other words, the importer
exchanges a fixed amount of Dollars for Euros so that he has the necessary
foreign currency to make payments in future. The importer is expected
to pay interest, at a fixed or floating rate, on the Euros borrowed
while the European trader pays interest on the Dollars to the importer.
On the maturity date of the swap, the currencies are exchanged so that
the parties have the currency they started out with. These swaps are
negotiable for at least 10 years, thus making them a highly flexible
strategy for currency hedging by importers.