Taking on risk
Businesses with operations overseas often take upon unnecessary risk when trading goods and services. When buying or selling shipments of electronics, for instance, the terms of contract often require a payment at a later date. This time delay produces a substantial risk as the medium of exchange, domestic or foreign currency often changes in value depending on factors such as economic releases, supply and demand, and governmental policy.
To fully illustrate the repercussions of a shift in an exchange rate, let’s examine the effects of the revaluation of the Chinese Yuan that occurred in July of 2005 on potential business dealings. First, the revaluation hurt any venture that exported goods or services from China. When China revaluated its currency and dropped its peg value from 8.31 to 8.11 Yuan to the dollar, the appreciation caused all goods and services from China to become more expensive. Investors and buyers now found themselves paying more for the same amount of goods or services. Second, the 2.5% move was modest in nature, and even expected by many speculators, but global price action ensued and the foreign exchange markets moved wildly.
Currency risk threatens any business with commercial relationships with countries experiencing substantial changes in its economies. Dealing with Japan, for example, is difficult since the Japanese restriction on capital outflow and rocky economic recovery make the exchange market for the dollar-yen volatile. If a business did not hedge its risk when trading in yen, it is exposing itself to a high degree of currency rate risk. Sudden changes can be disastrous for businesses that do not plan ahead by detracting from its bottom line.
Hedging
Hedging currency volatility is a vital component of protecting businesses from risk. To continue the revaluation example, 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. 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, such as one from Forex Capital Markets (http://www.fxcm.com), 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 buys 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.
So in conclusion, hedging in the spot market is a very effective and affordable way to protect against currency volatility. Since up to 100:1 leverage is available in a trading account, relatively little initial capitalization is needed. Trades can be made over the Internet, with no commissions or fees to pay.
Gerron Woodruffe is an affiliate of gocurrency.com. Go currency is a free online currency rate converter.
