What it means
Any business that buys or sells across a border carries currency risk between agreeing a price and receiving the cash. If a US exporter invoices in euros and the euro falls before payment arrives, the dollars received shrink even though the customer paid the agreed amount in full.
The most common tool is a forward contract, which fixes today the rate at which a set amount of currency will be exchanged on a future date. Options cost an upfront premium but leave the upside open, and futures do a similar job through an exchange with daily margining.
Hedging is not the same as removing risk; it is choosing a known outcome over an unknown one. A hedged exporter gives up the gain it would have made had the currency moved in its favour, and finance teams need to say that out loud before the first hedge is placed rather than afterwards.
In practice most companies hedge a proportion rather than everything, often on a rolling schedule such as 80% of the next quarter, 50% of the following one and 25% of the one after that. This layered approach smooths the average rate achieved and avoids betting a whole year on a single day's pricing.
There are also natural hedges that cost nothing at all. Buying supplies in the same currency the business sells in, borrowing in the currency of overseas revenue, or invoicing in the home currency all reduce exposure before any derivative is needed.
In practice
Real-world examples.
Example
A UK software company with 60% of revenue in US dollars and nearly all costs in pounds sells dollars forward each month against its subscription billing. The policy caps the swing in its reported gross margin at about 1 percentage point rather than the 4 points it saw in an unhedged year.
Example
A furniture importer buys a currency option rather than a forward ahead of an uncertain tender, paying a $14,000 premium on a $700,000 exposure. It loses the tender, lets the option lapse and is out only the premium, whereas a forward would have left it committed to buy currency it no longer needed.
Example
A mining services group borrows in Australian dollars to fund an Australian contract rather than converting from its home currency. The loan repayments and the contract revenue then sit in the same currency, creating a natural hedge that needs no derivative at all.
Formula
Calculation
Hedged proceeds = Foreign currency amount x Forward rate
Hedge benefit or cost = Hedged proceeds - (Foreign currency amount x Spot rate at settlement)
A US exporter will receive 2,000,000 euros in six months. Spot is 1.1000 dollars per euro and the bank quotes a six-month forward of 1.0950, so selling the euros forward locks in 2,000,000 x 1.0950 = $2,190,000.
If the euro falls to 1.0600 by settlement, an unhedged receipt would have been 2,000,000 x 1.0600 = $2,120,000. The hedge is worth $2,190,000 - $2,120,000 = $70,000 more.
If instead the euro rises to 1.1400, an unhedged receipt would have been 2,000,000 x 1.1400 = $2,280,000, so the hedge costs $2,280,000 - $2,190,000 = $90,000 of forgone upside.
In both cases the exporter banked exactly $2,190,000, which is the whole point: the budgeted figure held whatever the market did.Case study
Seen in the real world.
Bellhaven Textiles is a fictional mid-sized manufacturer used here as an illustrative example. It sold roughly 8,000,000 euros of fabric a year into Europe from a US base and priced its annual catalogue in euros each January using the rate available on the day.
In one year the euro fell from 1.1200 to 1.0400 between the catalogue date and the bulk of collections, cutting dollar revenue by 8,000,000 x (1.1200 - 1.0400) = $640,000 and turning a 6% operating margin into roughly 1%. The board approved a hedging policy the following January: sell forward 75% of forecast euro revenue in monthly instalments across the year, leaving 25% unhedged.
The next year the euro rose, and the hedged portion cost Bellhaven about $310,000 against what an unhedged position would have earned. The finance director's report framed that as the price of a catalogue price customers could rely on, and the board, remembering the $640,000, agreed.
Watch out
Common mistakes.
- Hedging only after the currency has already moved, which locks in the bad rate instead of protecting against it.
- Judging the hedge in isolation and calling a forward that lost money a failure, when the underlying receipt gained the same amount.
- Hedging 100% of a forecast that turns out to be optimistic, leaving the business committed to sell currency it never actually receives.
Questions
People also ask.
What is the difference between a forward and an option hedge?
A forward fixes the rate at no upfront cost but removes any upside, while an option costs a premium and protects the downside while leaving the favourable move available.
How much of an exposure should a business hedge?
Most companies hedge a declining proportion the further out the forecast goes, commonly heavy cover for the next quarter and lighter cover beyond, because forecast certainty falls with time.
Can a small business hedge without a bank credit line?
Often yes, through a regulated currency provider that takes a small deposit against the forward instead of requiring a full credit facility, though that deposit ties up cash.
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