Basic Concept: The forex hedge’s change in value is opposite to the change in value of the foreign currency exposure (hedged item). These two amounts offset each other to obtain cost certainty or revenue certainty by fixing the foreign exchange rate for your transaction.
There is typically a cost associated with forex hedging and generally, forex hedging will require a certain amount of margin cash (retail online forex broker) or available credit from your financial institution, while the forex hedge is outstanding.
There are a couple different methods to complete the forex hedges. For the assumed example, the company uses the United Stated Dollar (USD) as its reporting currency and it has a future Euro payable amount. With all forex hedges, your company is buying one currency and selling another currency.
1. Forward contract. Your company would purchase a forward contract from a banking institution which would give you the right to purchase a contracted amount of euros at a future date at a fixed price. Your future exchange rate would be based upon the current exchange rate, likely profit paid to the bank, and forward points. Forward points are calculated based on interest differential (interest carry costs) on the two currencies traded. You pay interest on the currency sold (USD) and you receive interest on the currency bought (euros). If you change the amount to be paid or the date of the expiry date of the contract, your financial institution will likely charge your company a fee.
· Your company will need adequate credit (borrowing capacity) with the financial institution, which supplies the forward contract.
2. Carry Spot Trade. With a retail online forex broker, you will enter into the carry spot trade whereby your company will buy the Euros and sell your local currency. Over the expected time frame between when you purchase the carry spot trade and complete the euro transaction in the future, your account will be charged the interest differential (interest carry costs). Once again, your company pays interest on the currency sold (USD) and you receive interest on the currency bought (euros). The carry spot trade may be partially or fully terminated at any time, which provides flexibility for when your euro transaction is completed.
· Your company will need adequate margin with the online retail forex broker, which enables the carry spot trade to be transacted.
3. Forex Options. A currency option gives the holder the right, but not the obligation, to sell or buy a face amount of currency at a set price, on or before a given date. A currency option has a strike price—the amount for which the currency can be bought or sold—and an expiration date. U.S. options can be exercised at any time up to and including the expiration date, whereas European options can only be exercised on the expiration date. Options are one-sided contracts that are priced based on a number of variables: exchange rates, interest differentials, duration of contract, historical exchange rate volatility, and a built-in commission for the provider. They offer a method of speculating on future currency movements, but you pay a price for that right to speculate.
4. Forex Exotics tend to be combinations of a variety of products (typically options and forward contracts) with many different names and flavors (including features such as floors, ceilings, collars, participating forwards). They are often sold with the promise of limited downside risk and the potential of unlimited or limited upside benefit. They’re similar to standard options, but should be left to very experienced forex traders because their complex structures often hide extra profits for their providers.
Remember, hedging is not about making money on the hedge transaction. Hedging is obtaining cost certainty or revenue certainty. You are locking in the future exchange rate for a certain future forex transactions.
As an example, let us assume you are a USD currency company. You plan to purchase $40,000 in European product in eight months. If you entered into a carry spot trade to buy 40,000 EUR/USD trade on an online retail forex platform , then you will receive cost certainty in an assumed eight months. With this example, the current EUR/USD price is 1.5600. The first currency listed is known as the quote currency and always equals 1. In this case, therefore, you would buy 1 EUR with selling 1.5600 USD. Your current USD expense is 62,400. (40,000 multiplied by 1.5600)
In the future, your euro payable is a (40,000), so your forex hedge will be to purchase the 40,000 euros on the carry spot trade by selling the USD.
If in the future, the EUR/USD price is 1.61, then you will have made $2,000 on your forex hedge trade [ 1.61 minus 1.56 = 0.05 multipled by 40,000 = $2,000], however, when you make the payment to the supplier, the 40,000 EUR would cost you 64,400 USD. Your net cost for the product would be $62,400 USD. (Actual cash payment to your supplier less the amount made on the forex hedge).
OR
If in the future, the EUR/USD price is 1.51, then you will have lost $(2,000) on your forex hedge trade[ 1.51 minus 1.56 = (0.05) multipled by 40,000 = $(2,000)], however, when you make the payment to the supplier, the 40,000 EUR would cost you $60,400 USD. Your net cost for the product would be $62,400. (Actual cash payment supplier plus the amount lost on the forex hedge.)
This is the hedge. The forex carry spot trade’s win or loss will be offset by the actual amount of money paid to the foreign supplier. In the end, you have obtained cost certainty for your company.
For all forex hedging, your company will pay (or receive) interest carry costs. When you open a carry spot trade as a forex hedge, you are simultaneously buying one currency and selling another. Until the trade is closed (settled), your account will be charged (or earn) the interest differential on the open position. You will be charged interest on the currency sold and you will earn interest on the currency purchased. In your example, you would be buying EUR and selling USD. At today’s interest rates (July 2008), the interest earned will exceed the interest paid, so while the forex hedge is outstanding, you will earn net interest. This will depend upon the two currencies traded.
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