Hedging Against Currency Changes
Kyle Ashcraft, CPA · 2019 CPA Exam Scores · 95 FAR · 98 BEC · 91 REG · 90 AUD
Foreign currency exposure is a real risk for any company that transacts internationally. Hedging is how a company protects itself against future price changes — in a currency, or in any other commodity.
What is a forward exchange contract?
A forward exchange contract locks in an exchange rate today for a transaction that will actually happen later. The rate available right now is the spot rate; the rate locked in for the future transaction is the forward exchange rate. Once the contract is signed, the company pays the forward rate regardless of where the spot rate actually ends up.
Worked example: hedging with Nomad Science
Nomad Science is a U.S. company that does a lot of business in Italy and transacts heavily in Euros. It's worried the U.S. dollar will weaken against the Euro — making Euros more expensive to buy in the future.
The current spot rate is $1.15 per Euro. Nomad Science enters a forward contract to buy 1 million Euros six months from now at $1.15 each, locking in that rate regardless of what the spot rate does in the meantime.
Six months later, the spot rate has moved to $1.20 per Euro — the dollar weakened just as Nomad Science feared. But because of the hedge, they still only pay $1.15:
Total savings = $0.05 × 1,000,000 Euros = $50,000
Had the spot rate moved the other way — say, down to $1.10 — Nomad Science would still be locked into paying $1.15, meaning they'd have overpaid by $0.05 per Euro relative to the market. That's the trade-off of hedging: it protects against the move you're worried about, at the cost of missing out if the market moves in your favor instead.
A forward contract trades uncertainty for certainty. The spot rate is whatever the market says right now; the forward rate is the one number a company locks in today so tomorrow's price swings — in either direction — no longer matter to that transaction.
Want the full BEC framework?
My free CPA 101 course covers the study approach I used to score 90+ on every CPA exam section.
More on derivatives and corporate finance
Kyle Ashcraft, CPA scored 90 or above on every section of the CPA exam in 2019, including a 98 on BEC. He is the founder and sole instructor of Maxwell CPA Review, a complete CPA review course covering all six sections, where he creates every lecture, textbook and study outline himself.
Study Tip: The spot rate is the current exchange rate between two currencies.