Mastering accounting - concepts, techniques, and applications

Lesson 62 - Advanced Accounting Course

Lesson 62: Hedging Foreign Exchange Risk Using Derivatives

🌍 What Is Foreign Exchange (FX) Risk?

Foreign exchange risk is the danger of losing money due to changes in currency exchange rates.

💡 Companies that buy, sell, borrow, or invest in foreign currencies face this risk.

🔄 Example:

A U.S. company sells goods to Europe and gets paid in euros (€).
If the euro weakens before payment, the company will receive fewer dollars. That’s a loss! 😞

🛡️ What Is Hedging?

Hedging means reducing or eliminating risk.
In FX, companies hedge to protect themselves from currency swings.

✅ Goal: Lock in future exchange rates and avoid surprises.

🧰 Tools Used to Hedge FX Risk (Derivatives)

1. 📅 Forward Contracts

Definition:
An agreement to buy or sell currency at a specific rate on a set future date.

🧾 Example:

A UK firm must pay $500,000 in 90 days.
It enters a forward contract today to buy USD at 1.25 GBP/USD.
Even if the rate changes to 1.35, it still pays the lower rate. ✅

2. 📊 Currency Options

Definition:
A contract that gives the right (not the obligation) to exchange currency at a specific rate before a set date.

🧾 Example:

A Japanese company expects a $1M payment in 60 days.
It buys a put option to sell USD at 145 JPY/USD.
If the USD weakens to 140, they exercise the option and save money.
If USD strengthens to 150, they ignore it and take the better rate.

3. 🔄 Currency Swaps

Definition:
Two parties exchange currencies and interest payments over time.

🧾 Example:

A U.S. firm borrows €10M in Europe, a German firm borrows $10M in the U.S.
They swap currencies and pay interest to each other.
Each gets the cash they need in the right currency 🏦