Hedging Currency Risk: Locking In with Forwards
An exporter won't receive €1 million for 3 months. If the exchange rate falls, the profit vanishes. What are the trade-offs between a forward contract and an FX option?
Risk warning: forex, CFDs, options, futures and crypto assets usually involve leverage or high volatility, and you can lose more than you put in. This lesson only teaches the concepts; all numbers are for illustration and are not investment advice.
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Text version · Hedging Strategies, lesson 6: “Hedging Currency Risk: Locking In with Forwards”
An exporter won't receive €1 million for 3 months. If the exchange rate falls, the profit vanishes. What are the trade-offs between a forward contract and an FX option?
Forward hedge: set a future exchange rate today
An exporter will receive foreign currency later and fears it will weaken. Sign a forward contract with a bank to convert in 3 months at a rate agreed today. The outcome is fully certain, but the benefit of the currency strengthening is locked away too.
FX options: protect against the bad case only
Buying a put option on the foreign currency sets a floor under the exchange rate: below it you convert at the agreed rate; above it you convert at the market rate. The cost is a premium.
Hedge only money that's sure to arrive
A forward is a contract you must honor. If the order is canceled and the euros never arrive, you still have to deliver euros as agreed, and the hedge becomes a naked euro short. Uncertain cash flows suit options better, or hedge only the part you're sure of.
Key takeaways
- A company that will receive foreign currency fears that currency falling; a forward contract locks in the exchange rate today.
- Locking in with a forward: your income is fixed whatever the rate does, but you give up the benefit of the foreign currency rising.
- Buying a put on the foreign currency: pay a premium for a "minimum exchange rate" while keeping favorable moves.
- Only hedge cash flows that are certain to happen; if the order is cancelled, the forward becomes a speculative position.
Try it yourself
You can do these exercises in this lesson's interactive simulation:
- Click "Example: euro falls to 1.00 after locking in": how many dollars does the forward bring in? How much less would you get unhedged?
- Drag the rate to 1.20: which of the three plans collects the most? Did the forward "lose"?
- Switch to "Buy a euro put" and drag the exchange rate from 0.95 to 1.25: where does the green line go from flat to sloped?
- Look at the forward rate of 1.1055 on the right: why is it higher than today's 1.1000? (Hint: US dollar rates are higher than euro rates.)
Quiz and explanations
- 1. You'll receive €1,000,000 in 3 months and have locked in a forward at 1.1055. At expiry the spot rate has fallen to 1.00. How many dollars do you receive?
- Answer: $1,105,500.The forward converts at the agreed 1.1055, regardless of the rate at expiry.
- 2. An exporter worried about the foreign currency it will receive losing value should hedge with options by…
- Answer: Buying a put on the foreign currency.A put sets a minimum selling price for the foreign currency.
- 3. An exporter sold €1,000,000 forward, then the customer cancelled the order and the euros won't arrive. What is the forward now?
- Answer: A short euro position with nothing behind it, which loses if the euro rises.You still have to deliver euros at expiry. Without the cash flow it was hedging, the forward has turned from a hedge into speculation. Only hedge cash flows that are certain to happen.
Terms in this lesson
- forward contract (Forward): An agreement to buy or sell on a future date at a price agreed today, often used to lock in an exchange rate.
- interest rate parity (Interest Rate Parity): The forward exchange rate is set by the interest rate gap between two currencies: the lower-rate currency trades at a higher forward price (a premium).
- premium (Premium): The price of an option, paid by the buyer to the seller; it's the most the buyer can lose.
- put option (Put): The right to sell the underlying at the strike price; the lower the stock goes, the more it's worth.
- short (Short): Borrow and sell first, then buy back to return it, betting the price will fall.