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FAQ - Investment Answers
what does hedging means and discuss whether it would be a suitable solution for company which is afraid of losing part of the company's profit margin because of exchange rate losses. - Posted by Anonymous
ANSWER 5th September 2010
Hedging is a strategy to cancel or partially cancel a potential risk. In your example let's say a UK company has won an export order to America. It has calculated its costs and has pitched the selling price to produce a certain profit margin. The only uncertainty is the sterling/dollar exchange rate that is going to prvail when the order is completed and the buyer has paid the bill. The risk is that the dollar will weaken from today's value and reduce the profit margin. To hedge out the risk the company would sell the expected dollars today through a forward contract. When the dollars are received they will be used to close the futures contract.
If the dollar does , in fact , depreciate it makes no difference because they have already been sold. If the dollar appreciates then, of course, the company would miss out on a higher profit margin.
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