Businesses Use FOREX to Hedge Business Transactions
Businesses that have significant financial transactions with other countries are at risk when their contracts are quoted in the currency of another country, due to relative fluctuations of the currency over the term of the contracts.
Currency risk threatens any business having commercial relationships with countries experiencing substantial changes in their economies. Sudden changes in currency valuation can be disastrous for businesses that do not plan for this contingency.
Hedging currency volatility is a vital part of protecting businesses from risk. A business owner with a contract to buy Japanese goods in United States dollars without a hedge would have encountered a ruinous blow during the revaluation of the Japanese Yen when the Chinese Yuan dropped its peg value from 8.31 to 8.11 Yuan to the dollar in July of 2005. The change in the Chinese Yuan caused the Japanese yen to increase in value against the dollar by over 200 pips. The dollar collapsed in the wake of the move and hit a low of 110.36 in early New York trading.
Individuals and businesses can easily reduce exposure to currency risk by taking positions in the spot currency market. If a US company doing business with the UK wants to protect itself against a depreciating dollar, then the appropriate hedge would be to sell dollars and buy pounds in the spot currency market. By using a trading account, the business can customize the amount of leverage it uses up to 100:1, so that a hedge is possible at a low cost.
A clear example of the necessity of a hedge is if an American importer is expecting a shipment of 400,000 euros worth of British goods in four months. Since his supplier will want payment in local currency, the importer will need to convert his dollars to euros. He will not be making a payment until the goods are delivered, however, and therefore the risk that the dollar may decline creates a possibility that the goods may be more expensive. To hedge his risk, he can buy 400,000 pounds in the currency market. If the dollar depreciates, and pound subsequently appreciates, his profit in his trading account will completely counterbalance any losses he would have incurred during his purchase of his suppliers’ goods.
Hedging is an effective and affordable way to protect against unforseeable price action in the currency spot market. Since up to 100:1 leverage is available in most trading accounts, relatively little initial capital is needed to create a successful hedge. Trades can be made simply and quickly over the Internet.
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