We know that changes in foreign currency can be risky. But how can a company protect itself against these changes? It can do so through an approach called hedging. When a company hedges, it protects itself against future price changes, whether involving currencies or other commodities.

For instance, assume that Nomad Science is a US company that does a lot of business with Italy, so it transacts a lot in the Euro. Suppose that Nomad Science is worried about the value of the US dollar decreasing relative to the Euro.

Imagine the current cost of one Euro is $1.15. This current rate is called the spot rate. The company decides to enter into a forward exchange contract where, six months from now, it will buy 1 million Euros for $1.15 each. This is referred to as the forward exchange rate; it’s the rate set for the future.

Regardless of what happens to the currency over the next six months, the company will pay $1.15 per Euro. If the company was correct and the Euro became more expensive, then the company benefits from the hedge. However, if it turns out that the value of the Euro decreased, then Nomad Science would be adversely affected by the transaction.

Let’s say that after six months, one Euro costs $1.20 (spot rate), meaning that it became $0.05 more expensive to purchase one Euro. Because the company entered into a hedge, it saved $0.05 per Euro ($1.20-$1.15) for a total of 1 million Euros. Thus, it saved a total of $50,000 because of the hedging ($0.05 X 1,000,000). This is how hedging with foreign currency works.

Study Tip: The spot rate is the current exchange rate between two currencies.