Currency hedging

What is hedging? Hedging is a strategy used to protect risks posed by worldwide currency fluctuations. One hedges the currency risk by contracting to sell foreign currency in the future, at the current exchange rate (Fries). If fund managers think the dollar is going to be stronger when they are ready to change the foreign currency back into American dollars, then they take out a foreign futures contract (a hedge). Thus, they lock in the exchange rate beforehand, so that they will not lose profits gained from holding devalued foreign currency (Hedging, 1999). If the manager guesses correctly, he will boost the fund’s overall return because the profits will be worth even more when they are exchanged into American dollars.
The foreign exchange market is one of the most important financial markets. It influences the relative price of goods between countries and can shape trade. It influences the price of imports and can have an effect on a country’s price level (inflation rate). In addition, it influences the international investment and financing decisions. Exchange rates present many risks to a company and a company must be able to hedge itself (Gray, 2003).
The price of one currency expressed in terms of another currency is called an exchange rate (Gray, 2003). Foreign investors need to sell in a foreign currency to be competitive. By making the most of the exchange rate risk, it may take away some of the risk of the cross border trade from customers. This in turn may encourage a customer to buy products.
Exchange rates are the amount of one country’s currency needed to purchase one unit of another currency (Gray, 2003). Typically, vacationers wanting to exchange money will not be bothered with shifts in the exchange rates. However, for multinational companies, dealing with very large amounts of money in their transactions, the rise or fall of a currency can mean receiving a surplus or a deficit on their balance sheets, which is an example of translation risk. Translation risk is more of an accounting issue, and refers primarily to the impact of exchange rates on earnings and balance sheet items (Hedging, 1999).
Another type of exchange risk faced by multinational companies is transaction risk. If a company sells products to an overseas customer, it might be subject to transaction risk. Transaction risk refers to actual conversions of cash flows from one c...

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...to the American dollar will affect the total loss or gain on the investment when the money is converted back. This risk usually affects businesses, but it can also affect individual investors who make international investments, also called currency risk (Investorworld).

References

http://www.investorwords.com/1808/exchange_rate_risk.html retrieved February
27, 2005
Fries, Bill. Thornburg Articles. Currency Hedging retrieved February 24, 2005 from http://www.thornburginvestments.com/research/articles/Currency%20Hedging.asp Gray, Phil and Irwin, Tim. (2003). Allocating Exchange Rate Risk in Private
Infrastructure Contracts retrieved February 24, 2005 from http://rru.worldbank.org/Discussions/Topics/Topic21.aspx Hedging Currency Risk with Options and Futures retrieved February 25, 2005 from http://www.goldencapital.com/research/reports/hedging.htm Kaepplinger, Peter (1990). The CPA Journal Online Foreign currency hedging transactions under Section 988Temporary regulations
Retrieved February 24, 2005 from http://www.nysscpa.org/cpajournal/old/08660556.htm