Can anyone explain, in simple terms, how futures contracts can be used to hedge a foreign currency risk ?

Answer 1

Futures allow you to lock in a price today for something like foreign currency. If you are investing in Japanese bonds that are maturing in 3 months and you want to convert them back into dollars but don't want to risk the dollar dropping in value, you could just buy a futures contract on dollars and lock the price in today.

Answer 2

As with any futures contract, you are buying a promise to deliver the commodity or currency at some future date. It is a uniform amount but a fluctuating price.

Say you know you are going to buy some wheat in March. It isn't March now, but you can buy a contract for 5,000 bushels at todays price, putting just a little piece of it down to hold the contract in your name, and when it matures in March (or whatever month you bought into), then you pay the rest and the issuer of the contract sends you a delivery notice (its in this grain elevator, where do you want it?). The same thing happens with currency. I'm going to sell my grain to China and buy a bunch of shirts. But the company I'm trading with wants to get paid in Yen and the value of the shirts exceeds in a sizeable way the value of the wheat I'm shipping. So I can take my chances at the exchange rate, or I can possibly get a good price on Yen delivered (made available) in March when the trade is to take place.

I can buy a spread, selling one month and buying another month, say February and March. If the price goes against one or the other, I step out of the losing direction and the winning direction then balances out (hopefully) the losses in the other side of the spread. This gives a cheap opportunity to protect value if the price of the commodity, or currency in this case, changes a lot. Then I can either take the money in February or March, in this example, depending upon which is more advantageous. I don't have to hope at what the exchange rate is, I can follow it as it fluctuates until I need it, discarding the direction that is wrong.

Answer 3

You have a shoe store and you buy shoes from Nike in Mexico and each shoe costs $500.00 MXN and you sell them for $100.00 USD.

Today $500.00 MXN costs $50.00 USD so you get a very good deal.

Tomorrow the shoe still costs $500.00 MXN.
However, $500.00 MXN now cost $75.00 USD

You still make money but your are making less money on the same exact shoe.

What if you ask your bank for a loan and you make your calculations based on those $50.00 USD you were making and now you cannot make the payments despite the fact you are still selling the same shoes?

The Mexican Pesos are too much risk for you.

Therefore you find someone that is willing to sell you the MXN you need in the future at the same $50.00 USD you are paying now.

You buy a contract to buy Mexican Pesos at the same price you are paying today.

As you can see the other guy selling you the futures is taking a very big financial risk.

However, you no longer have to worry about that anymore and you can buy all the Nike shoes you need from Mexico at the same price you are paying now in the future.

If your competition buys the same shoes from Nike but they don't buy any insurance against foreign currencies they will be forced to close and you will be fine.

If the opposite happens then your competition makes more money and you only make $50.00 USD

As you can see futures are very risky.

However, if you buy OPTIONS instead of futures you have only the right to buy the MXN but not the obligation.

This is the best way to hedge your risks.

I hope you understand.

If you still have questions you can email me.

Answer 4

in the most simple way I can explain it -

if you're buying australian copper and the price of the aussie currency (AUD) goes up, you lose money on the exchange while the aussie firm makes money on you... so, you hedge by buying AUD contracts so that if AUD goes up the money you make on the futures contract should offset what you lose in buying aussie goods...

works the same if the currency goes down - you lose on the contract but the aussie goods cost less to offset this