Hedging: Minimizing Risk in Foreign Exchange Transactions

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Hedging: Minimizing Risk in Foreign Exchange Transactions We live in a global, interconnected world today. We can talk face to face with another person on a PC, tablet, or smartphone that may be on the other side of the world, a situation not even considered not too many years ago. With the advent of the Internet, we as consumers can purchase items from anywhere in the world with the click of a button. Foreign transactions such as this are subject to currency exchange rates, in which we may pay with US dollars, but the currency of the country from which we made the purchase is not equal to US dollars. While this situation may not impact the average consumer, companies that engage in foreign transactions with international companies could face losses, and gains, due to changes in the foreign currency exchange rate. US companies that do business with foreign companies have to be careful to not incur losses when making purchases or sales due to fluctuating foreign currency exchange rates. A company may make use of derivatives to minimize transaction exposure losses when engaging in business with foreign companies and currencies. The use of a derivative by a company who is trying to insulate itself against this type of loss is called hedging. Although hedging has its supporters and detractors, as well as its advantages and disadvantages, it is a common practice in our global business world today. As is common in most transaction situations between companies, American companies who engage in transactions with international companies often make a sale or purchase on one certain date, but the actual funds transfer between the companies often takes place at a point in the future. During this time span, a change in the currency exchange rate causes the amount of the revenue or expenditure to be unknown for the American company. As an example, suppose ABC

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