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After identifying FX exposure (Topic 6), the next step is hedging—reducing uncertainty of foreign currency cash flows. Hedging does not always mean “avoid loss”; it means lock/manage the exchange rate so that cash flows become predictable. Firms hedge mainly to protect profit margins, budgets, and liquidity.
This chapter covers the most common hedging methods used in international finance:
Hedging is taking a position/arrangement that reduces or offsets the risk of adverse exchange rate movement.
Why firms hedge:
Forward contract is an agreement to buy/sell a specified amount of foreign currency at a fixed rate on a future date.
Features:
Use cases:
Currency futures are standardized contracts traded on an exchange to buy/sell currency at a future date.
Key features:
Choice depends on size, flexibility needed, and market availability.
Option gives the right (not obligation) to buy/sell currency at a fixed rate (strike) on/before a date.
Types:
Important exam idea:
Money market hedge uses borrowing/lending to lock in a home-currency cost/receipt.
Idea:
It creates a synthetic forward using interest rates.
Currency swap is an agreement between two parties to exchange principal and interest payments in different currencies over a period.
Uses:
Firms often define a hedge policy: exposure threshold, approved instruments, limits, and reporting.
Advantages:
Limitations:
Identify exposure → choose instrument (forward/future/option/MM hedge/swap) → execute hedge → monitor → settle/rollover
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After identifying FX exposure (Topic 6), the next step is hedging—reducing uncertainty of foreign currency cash flows. Hedging does not always mean “avoid loss”; it means lock/manage the exchange rate so that cash flows become predictable. Firms hedge mainly to protect profit margins, budgets, and liquidity.
This chapter covers the most common hedging methods used in international finance:
Hedging is taking a position/arrangement that reduces or offsets the risk of adverse exchange rate movement.
Why firms hedge:
Forward contract is an agreement to buy/sell a specified amount of foreign currency at a fixed rate on a future date.
Features:
Use cases:
Currency futures are standardized contracts traded on an exchange to buy/sell currency at a future date.
Key features:
Choice depends on size, flexibility needed, and market availability.
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From this topic
Forward hedging (any three points):
Thus, forward contracts provide certainty of exchange rate for future cash flows.
Table:
Hence, futures are more standardized and safer, while forwards offer flexibility.
Meaning: A currency swap is an agreement where two parties exchange principal and periodic interest payments in different currencies for a specified period.
Flowchart:
Two parties with opposite currency needs → exchange principal → exchange interest payments over time → re-exchange principal at maturity
Conclusion: Currency swaps are powerful instruments for long-term FX risk management and international financing strategy.