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Protecting Your Profits in an International Market

In today's international environment, more and more businesses are engaging in international commerce – and hence are far more vulnerable to exchange rate movement. In some instances, fluctuations of exchange rates can have a devastating affect on a company; for example, if a firm exports its products and its native currency rises sharply in value, it may suddenly find that its product is too expensive for its clientele, and hence its sales plummet. Alternatively, if a firm is importing raw materials and its home currency falls sharply in value, it may find that the cost of raw materials rises sharply, thereby increasing the overall cost of production and decreasing profits.

For the increasing number of businesses that face this dilemma, there is a solution: hedging. “Hedging” is essentially the term used to describe the minimization of any particular risk item. For example, if a business hedges its exchange rate risk, it has found a way to minimize the risk associated with exchange rate movement. And through the FX market, businesses can do just that.

There are essentially two ways a firm can hedge its exchange rate risk:

Opening Contradictory Positions.

After setting up an account with an FX trading firm, the business can hedge its exchange rate risk by opening a position opposite to the one they entered to conduct business. For example, suppose a large furniture manufacturer with headquarters in Canada sets up a subsidiary in Italy. Part of financing the subsidiary will involve selling Canadian dollars and buying euros. In order to ensure that potential profits are not lost when revenue is converted back from euros to Canadian dollars, the furniture manufacturer could open a position in the FX market to buy Canadian dollars and sell euros. This is the opposite of what the initial position was, and hence the two cancel each other out. As a result, the firm has hedged itself against exchange rate risk.

Options.

Options are an investment tool designed specifically for hedging. Simply put, an option is the right – not the requirement, but simply the right, or option – to buy an asset at a pre-specified price and time. For instance, suppose a car manufacturer in Germany wants to lock in the price of US steel while the US dollar is still relatively low in value compared to the euro (thereby making it inexpensive for the German manufacturer to purchase the steel). In this case, the German manufacturer can purchase an option to buy US dollars and sell euros at a predetermined price – called the strike price -- on a predetermined date (called the expiration date). If the US dollar is trading above than the strike price on the expiration date, the car manufacturer can choose to exercise the option – thereby securing the lower exchange rate, and profiting as a result. Alternatively, if the US dollar is valued below the strike price at the time of expiration, the car manufacturer would not want to exercise the option, as the market rate for the US dollar is even lower than the price specified in the option. This shows the value of the option: if the market continues to move favorably, it can benefit the hedging entity; alternatively, if the market moves against the hedging entity, the firm can still use the option to secure a better rate. In this scenario, options are quite similar to insurance policies.