The average consumer only thinks about currency exchange rates once in a while – when he or she is headed for an overseas vacation, or perhaps when contemplating the purchase of a condo in a tropical paradise. But for companies that operate in a number of countries, exchange rates are a source of constant concern, especially when they are particularly volatile. This is because of the impact of currency fluctuations on both the top-line and the bottom-line.

Currency risk can be effectively hedged by locking in an exchange rate, which can be achieved through the use of currency futures, forwards, and options. In recent years, the rise of exchange-traded funds offers another method to hedge currency risk. We discuss below each of these methods to lock in an exchange rate, with the help of examples.

With Currency Futures

Currency futures enable a trader to buy or sell a fixed amount of currency at a set rate for a defined period of time. Futures are a popular avenue to lock in an exchange rate because of their advantages: the contracts are of standardized size, have excellent liquidity, and little counterparty risk because they are traded on an exchange, and they can be bought with a relatively small amount of margin. On the flip side, a futures contract represents a binding obligation, and the buyer must either take delivery or unwind the futures trade before expiration. In addition, futures contracts cannot be customized and the degree of leverage can be dangerous if not handled properly.

Example: You are a US citizen and have finally found the vacation property you always wanted to buy in Spain. You have negotiated a purchase price for the round sum of 250,000 euros (EUR), payable in less than two months. You think this is the right time to buy in Europe (circa April 2015) because the euro has tumbled 20% against the US dollar over the past year, but you are concerned that if the never-ending Greek saga gets resolved, the euro may soar, and increase your purchase price significantly. You, therefore, decide to lock in your exchange rate with currency futures.

To do so, you buy two euro futures contracts traded on the Chicago Mercantile Exchange (CME). Each contract is worth 125,000 euros and expires on June 15, 2015. The contracted exchange rate is 1.0800 (or EUR 1= $1.0800). So you have effectively fixed the amount payable for your EUR 250,000 obligation at $ 270,000. The margin payable is $3,100 per contract, or a total of $6,200 for two contracts.

How does the hedging work? Consider the two possible options with regard to the exchange rate very shortly before settlement on June 15 (ignoring the third possibility, that the spot exchange rate is exactly equal to the contracted exchange rate of 1.08 at expiration).

  • The spot exchange rate on June 15 is 1.20: Your hunch was right and the euro has indeed soared more than 10% since you bought the futures contract. In this case, you take delivery of EUR 250,000 at the contracted rate of 1.08, and pay $270,000. The hedge has saved you $30,000, based on the $300,000 you would have had to pay if you had purchased the EUR 250,000 in the forex market at the spot rate of 1.20.
  • The spot exchange rate on June 15 is 1.00: Assume the euro has slipped even further as Greece's exit from the European Union looks quite likely. In this case (and with the benefit of hindsight), although you would have been better off buying euros at the spot rate, you have a contractual obligation to buy them at the contracted rate of 1.08. Your hedge in this case has resulted in a loss of $20,000, since your EUR 250,000 will cost you $270,000 instead of the $250,000 you could have paid in the spot market.

What if the euro rises a couple of weeks before the contract expires, say to a level of 1.10, and you expect it to subsequently decline below your contracted rate of 1.08? In this case, you could sell the futures contract at 1.10, pocketing a gain of $5,000 ( {1.10 – 1.08} x 250,000), and then buy the euro at a lower price if the euro does decline as you had predicted.

What if the purchase deal for the vacation property falls through and you no longer need the euros? If this occurs, you could sell the two futures contracts at the prevailing price. You would make a profit if the price at which you sell were above the contracted rate of 1.08, and a loss if the selling price is below 1.08.

With Currency Forwards

Currency forwards are generally restricted to large players like corporations, institutions, and banks. The biggest advantage of forwards is that they can be customized with regard to amount and maturity. But since currency forwards are traded over-the-counter and not on an exchange, counterparty risk and liquidity are more significant issues than they are for futures.

Example: Hypothetical firm Big Bang Co. based in Japan has an export receivable of $1 million expected in six months. It is concerned that the Japanese yen could appreciate by then, which means that it would receive fewer yen when it sells the dollar, and decides to lock in the exchange rate using currency forwards with its bank.

The spot rate is 119.50 ($1= JPY 119.50). Forward rates are based on interest rate differentials, and the currency with the lower interest rate trades at a forward premium to the currency with the higher interest rate. Since yen interest rates are lower than dollar rates, the yen trades at a forward premium to the dollar. The six-month yen forward thus incurs a cost of 30 pips, which means that Big Bang Co. gets a rate of 119.20 (i.e. 119.50 – 0.30) for the $1 million it will sell to its bank in six months.

Assume the Japanese yen is trading at a spot rate of 116 in six months. Big Bang Co. receives a rate of 119.20 yen for its dollars regardless of where the spot rate is trading. It, therefore, receives 119.2 million yen for its dollar sale, which is 3.2 million yen more than it would have received had it sold the dollar receivable at the spot rate of 116.

If Big Bang Co does not want to deliver the $1 million to the bank for some reason, it could unwind the hedge by buying back $1 million at the spot rate of 116, for a gain of 3.2 million yen, and selling the $1 million received from its export at the spot rate of 116. The net rate it receives will still be 119.20 per dollar (3.2 + 116).

While currency forwards are not accessible to the general public, investors can effectively construct forwards using a technique called the money market hedge.

With Currency Options

The advantage of using a currency option to fix an exchange rate, rather than using futures or forwards, is that the buyer of the option has the right but not the obligation to buy the currency at a pre-determined rate before the option expires. Although there is an upfront cost in the form of the option premium, this cost may be preferable to being locked into an inflexible rate, as would be the case with currency forwards and futures.

Example: Going back to the first example, let's assume that you want to hedge the risk of the euro moving higher, while retaining the flexibility to buy the euro at a lower rate if it declines. You, therefore, buy two June 108 call options on the euro futures contracts. The contracts give you the right to buy 125,000 euros per contract at a rate of 1.08 (EUR 1 = USD 1.0800) for a premium of 0.0185. Your option premium payable is $2,312.50 (EUR 125,000 x 0.0185) per contract, for a total of $4,625.

There are three possible scenarios that arise just before the call options expire in June.

  • The euro is trading at 1.20: In this case, your options would be well in-the-money. Note that your effective exchange rate, including the option premium, is 1.0985 (i.e., the strike price of 1.0800 + the option premium of 0.0185).

In this case, the total cost of your EUR 250,000 is $274,625 ({two contracts X EUR 125,000 per contract X the call strike price of 1.08} + option premium of $4,625). The call option thus saved you $25,375, since buying at the spot rate of 1.20 would have cost you $300,000.

  • The euro is trading at 1.00: In this case, you would simply let your options expire and buy the euros at the spot rate of 1.00. Since you paid $4,625 in option premium, your total cost would be $254,625 (i.e. $250,000 + $4,625), which translates into an effective exchange rate of 1.0185.

In this case, you were much better off hedging through an option contract rather than a futures contract, as the latter would have resulted in a loss of $20,000, rather than the $4,625 you paid as option premium.

With an Exchange-Traded Fund

For small amounts, one can also use a currency exchange-traded fund (ETF), such as the Euro Currency Trust (FXE) to lock in an exchange rate. (See: "Hedge against exchange rate risk with currency ETFs".) The problem is that such ETFs have a management fee, which increases the cost of the hedge. There may also be some slippage between the ETF price and the exchange rate. The money market hedge may be a better alternative to ETFs to lock in an exchange rate for small amounts.

The Bottom Line

Exchange rates can be effectively locked in using currency futures, forwards, or options, each of which has pros and cons. For smaller amounts, the money market hedge may be preferable to ETFs for locking in an exchange rate.

Disclosure: The author did not hold positions in any of the securities mentioned in this article at the time of publication.

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