How Do You Use Derivatives To Manage Foreign Exchange Risk?
Businesses and financial institutions that operate in foreign countries want to protect the value of their investments against fluctuations in currency exchange rates that can devastate profits. Derivatives are a standard method of hedging (protecting) financial positions. A derivative is a security that depends on an underlying asset or another security for its value. For persons unfamiliar with the world of foreign currency exchange this may be confusing. However, if you think of hedging with derivatives as buying insurance in case something goes wrong, you’ll have the basic idea in a nutshell. The most common derivatives to manage foreign exchange risk are forwards and currency swaps. Understand the nature of foreign exchange risk. Let’s say you are exporting goods to Europe and the exchange rate is US $1.25/euro. In other words, for every euro in revenue you’ll get $1.25. However, suppose the dollar gets stronger (meaning it takes fewer dollars to buy a euro) and the exchange rate
