Hedging is a common strategy for managing exchange rate risk from "summary" of International Financial Management, Abridged Edition by Jeff Madura
Hedging is a common strategy used by companies to manage the risk associated with fluctuations in exchange rates. When a company engages in international trade, it is exposed to the risk of exchange rate movements, which can significantly impact its profitability. By hedging, a company can protect itself against potential losses that may arise from adverse movements in exchange rates. There are various hedging techniques that companies can use to manage their exchange rate risk. One common hedging technique is the use of forward contracts. A forward contract is an agreement between two parties to exchange a specified amount of one currency for another currency at a predetermined exchange rate on a future date. By entering into a forward contract, a company can lock in an exchange rate and eliminate the risk of unfavorable movements in the exchange rate. Another hedging technique that companies can use is the use of currency options. A currency option gives the holder the right, but not the obligation, to buy or sell a specified amount of currency at a predetermined exchange rate within a specified period. Companies can use currency options to protect themselves against adverse movements in exchange rates while still allowing them to benefit from favorable movements. By using these hedging techniques, companies can mitigate the risk of exchange rate fluctuations and protect their profits.
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