Currency risk is an important consideration for businesses dealing in international trade. Because exchange rates can be fluid and many foreign importers will prefer to pay you in their own currency, you may not receive the payment you expect – especially if you have to wait for it.
In these cases, you can use a forward contract to hedge this risk and protect your expected profits. A forward contract is arranged so that you can profit from the contract if there’s an unfavorable movement in the currency in which you’ll be paid.
Here’s an example:
Let’s say you’re selling to a company in India. You’ve arranged to sell $100,000 in goods payable in 90 days. The Indian company wants to pay you in Indian rupees.
You note that today the Indian rupee is valued at 59.6 rupees per one U.S. dollar. So technically speaking, at today’s exchange rate, you’re really selling your goods for 5.96 million rupees (59.6 x $100,000).
You also see that over the past year, the rupee has been valued as high as 68.8 rupees per one U.S. dollar and as low as 54.5 per one U.S. dollar.
If in 90 days the Indian rupee did rise to 68.8 rupees per U.S. dollar, you will receive that 5.96 million rupees you contracted for. But when you exchange them for U.S. dollars, those rupees will only be worth about $86,627 (5.96 million divided by 68.8). That could easily eat into your profits and then some.
Of course the rupee could fall. If it’s worth 54.5 rupees per one U.S. dollar when you’re paid, you could convert those 5.96 million rupees into $109,357 (5.96 million divided by 54.5) – a premium on your 100,000 sale.
But you’re an exporter, not a currency speculator, so taking on that risk may be unacceptable.
Fortunately, you can buy a forward contract at today’s rupee exchange rate. For a relatively small fee, you can set up a contract to buy $100,000 worth of rupees at the current exchange rate, payable at some point in the future (preferably when you expect to be paid).
You’ll either gain money if the rupee falls, but owe the difference when you close your forward contract. If the rupee rises, you’ll lose money on your transaction, but will be able to sell your forward contract at a profit. Either way, you’ll receive the $100,000 you contracted for if you have a forward contract in place.
The Export-Import Bank or your own bank can further explain how currency hedging works and help you set up a forward contract to protect you against currency risk.