Hedging Instruments

Having assessed its level of currency risk exposure, the firm attempts to balance exposed assets and exposed liabilities. The four most common hedging instruments are forward contracts, futures contracts, currency options, and currency swaps.

A forward contract is an agreement to exchange two currencies at a specified exchange rate on a set future date. No money changes hands until the delivery date of the contract. Banks quote forward prices in the same way as spot prices—with bid and ask prices at which they will buy or sell currencies. The bank’s bid–ask spread is a cost for its customers.

Forward contracts are especially appropriate for hedging transaction exposure. Suppose Dow Chemical (www.dow.com) sells merchandise ...

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