Hedging Exchange Rate | Currency risk using Currency futures
Simply think of these as items you can buy and sell on the futures market and whose price will closely follow the exchange rate. Let’s say that a US exporter is expecting to receive €5m in three months’ time and that the current exchange rate is US$/€1.24. Assume that this rate is also the price of US$/€ futures. The US exporter will fear that the exchange rate will weaken over the three months, say to US$/€1.10 (that is fewer dollars for a euro). If that happened, then the market price of the future would decline too, to around 1.1. The exporter could arrange to make a compensating profit on buying and selling futures: sell now at 1.24 and buy later at 1.10. Therefore, any loss made on the main the currency transaction is offset by the profit made on the futures contract.
This approach allows hedging to be carried out using a market mechanism rather than entering into the individually tailored contracts that the forward contracts and money market hedges require. However, this mechanism does not offer anything fundamentally new.
Basis risk can arise for both interest rate and exchange rate hedging through the use of futures. Futures contracts will suffer from basis risk if the value of the futures contract does not match the underlying exposure. This occurs when changes in exchange or interest rates are not exactly correlated with changes in the futures prices.
Note that another form of basis risk also exists as part of interest rate risk. In this case basis risk exists where a company has matched its assets and liabilities with a variable rate of interest, but the variable rates are set with reference to different benchmarks. For example, deposits may be linked to the one-month LIBOR rate, but borrowings may be based on the 12-month LIBOR rate. It is unlikely that these rates will move perfectly in line with each other and therefore this is a source of interest rate risk.