Companies that do business in foreign countries are exposed to risk due to fluctuations in currency values when they buy or sell goods and services outside their home markets. Foreign exchange markets provide a way to hedge currency risk by setting the rate at which a transaction will be completed.
To achieve this, a trader can buy or sell currencies in the forward or swap markets in advance, thus fixing the exchange rate. For example, imagine that a company plans to sell American-made blenders in Europe when the exchange rate between the euro and the dollar (EUR/USD) is 1 euro to 1 dollar at par.
The cost of manufacturing the mixer is $100, and the American company plans to sell it for 150 euros – a competitor to other mixers made in Europe. If this plan succeeds, the company will make a profit of $50 per sale because the EUR/USD exchange rate is equal. Unfortunately, the value of the US dollar begins to rise against the euro until the EUR/USD exchange rate reaches 0.80, which means that it now costs 0.80 USD to buy 1.00 EUR.
The problem facing the company is that while the blender still costs $100 to make, the company can only sell the product at the competitive price of €150 – which, when translated into dollars, is only $120 (€150 x 0.80 = $120). The strong dollar resulted in much lower earnings than expected.
The mixer company could have reduced this risk by shorting the Euro and buying the US Dollar when they were on par. In this way, if the value of the US dollar rises, the profits from the trade will offset the lower profit from selling the mixers. If the value of the US dollar falls, a more favorable exchange rate will increase the profit from the sale of mixers, offsetting losses in trade.
Hedging of this type can be done in the currency futures market. The advantage that a trader has is that futures contracts are standardized and liquidated by a central authority. However, currency futures contracts may be less liquid than futures markets, which are decentralized and exist within the worldwide interbank system.