How to reduce foreign exchange risk

Written by dicky cheungcorp
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How to reduce foreign exchange risk
Risk management is essential in foreign exchange. (Euros, twenty and fifty image by Warren Millar from

The profits of a corporation that operates in more than one country depend very much on the foreign exchange rates. Foreign exchange rates can fluctuate up and down, and thereby positively and negatively affect the actual profits of a company. It is therefore very important that companies know how to minimise their exchange rate risks so as to maximise their profits and increase their equity.

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    Hedge using futures or forwards contracts. This is the most common way of managing foreign exchange risk. A company will offset foreign currency holdings with futures and forward contracts. A futures contract is, according to Investopedia, "a contractual agreement, generally made on the trading floor of a futures exchange, to buy or sell a particular commodity or financial instrument at a predetermined price in the future." A forward contract is a transaction in which the delivery of the commodity is postponed until the contract has been made. The delivery is often in the future, however, the price is well determined in advance. Hedging is the act of taking an offsetting position in a related security. A good example would be if you own a currency, you will sell a futures contract stating that you will sell the currency at a set price in the future. A perfect hedge can reduce risk to nothing except the cost of the hedge.

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    Use options trading as a strategy to reduce foreign exchange risks. Just like stocks, currencies have calls and puts that allow buyers to buy or sell the financial asset at a predetermined price during a certain period of time or on a specific date (exercise date). Investopedia considers options the most dependable form of hedge. When traditional positions are used with a forex option they can minimise the risk of loss in a currency trade.

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    Use swaps. As described by Investopedia, "If firms in separate countries have comparative advantages on interest rates, then a swap could benefit both firms. For example, one firm may have a lower fixed interest rate, while another has access to a lower floating interest rate. These firms could swap to take advantage of the lower rates." For example, company A is based in the United States and company B is based in England. Company A needs to take out a loan denominated in British pounds and company B needs to take out a loan denominated in U.S. dollars. These two companies swap to take advantage of the fact that each company has better rates in its respective country. When these two companies swap, they will be able to save on interest rates by combining the privilege they have in their own country's market.

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