Currency hedging helps businesses protect themselves against changing currency exchange rates (the rates that determine the relative values of different currencies).
To hedge on currency, a company makes a “forward agreement” with an investment dealer to sell a specific amount of a particular currency on a future date—but at today’s exchange rate. This forward agreement is carried out through an exchange traded fund (a type of investment).
By locking in at today’s exchange rate through an exchange traded fund, the company will not gain if the value of the currency goes up, but will be protected from losses if the value of the currency goes down.
More about currency hedging
The following example shows how currency hedging works.
ABC Company has a contract to sell goods valued at C$100,000 to a Chinese client, who has agreed to pay in Chinese Yuan.
At the time of the contract, the Canadian dollar and Chinese Yuan are equal in value. If the Yuan drops in value before the customer pays for the goods—e.g., falls to 2 Yuan per C$1—the payment in Yuan would be worth only C$50,000. Currency hedging would be an effective way to mitigate or avoid this loss.