Hedging

Hedging is a way for a company to minimize or eliminate foreign exchange risk. Two common hedges are forward contracts and options. A forward contract will lock in an exchange rate today at which the currency transaction will occur at the future date. An option sets an exchange rate at which the company may choose to exchange currencies. If the current exchange rate is more favorable, then the company will not exercise this option. The main difference between the hedge methods is who derives the benefit of a favorable movement in the exchange rate. With a forward contract the other party derives the benefit, while with an option the company retains the benefit by choosing not to exercise the option if the exchange rate moves in its favor.