3.1.2.1. Hedging and Cross Hedging
To hedge against the risk of volatile exchange rates, an importer or investor must first determine the required hedge ratio. The required hedge ratio is calculated by dividing the amount of local currency at risk by the size of the futures exchange contract. A U.S. wine importer who has agreed to purchase €500,000 of French wine to be delivered in 60 days will hedge that purchase with 4 euro futures contracts, since each euro contract is worth €125,000.
hedge ratio = 4
Exporters generally like to do business in their own currency, so it is the importer that usually faces foreign exchange risk. For instance, typically, a French cheese exporter will be paid in euros, while a French car dealer who imports Japanese cars will need to pay for them with yen. To hedge this currency risk, a French car dealer may buy FX yen futures. This is because the French car dealer fears the yen may strengthen against the euro, making the yen more expensive in euros. This is a problem for importers because they must pay for goods (or the price to produce goods) in a foreign currency.
Example: A U.S. importer contracts for a shipment of French wine to be delivered in three months valued at €375,000. The cash price for euros is currently $1.1210, and the futures contract is selling at $1.1254. Fearing a strengthening of the euro and a weakening of the dollar, the importer buys three futures contracts (€375,000 / €125,000 = 3). The euro does indeed strengthen, with the spot price rising to $1.1215 and the futures contract to $1.1262. The importer now must pay more dollars to get the same number of euros. But the futures rate has also increased. The euro futures he bought can now be sold at a higher dollar price. The profit he makes by offsetting the futures contract will more than compensate for the losses he has incurred in the spot market.