Why do international companies regularly use currency hedging?

Answer 1

Companies hedge currencies because currency values fluctuate. The hedge allows for a control valve on price changes. In the most simple sense:

A farmer is thinking about growing corn. He sees by the price of corn in the futures market that growing corn would generate a good profit, but what if the price changes between right now and when the corn is grown? He could "lose the farm." So he hedges. He calls his broker and SELLS corn on the futures market today (SELLS SHORT.)

Three months later the corn has grown and he brings it to market, but the price has changed! Not to worry, he hedged. he receives $1 less per bushel due to the price change, BUT then he goes home and calls his broker and "OFFSETS" the hedge at the exchange resulting in a $1 per bushel profit. Viola! The exchange gain has offset the corn actuals market loss, and the farmer has earned his expected profit. The hedge saved the farm.

This is the most common and simple hedge - A SELL HEDGE.

What may be confusing you is that in currency, you may have a BUY SIDE HEDGE OR as SELL SIDE HEDGE. I'll start with the buy side example:

Let's say you are an American TequilaImporter. In May you place an order for tequila, to be delivered in August. The manufacturer insists on being paid in Pesos. So in essence, in August you will need to take your dollars, and BUY (convert) to Pesos. But what if the price of the peso changes (Goes Up)? We could lose our potential profit! So we hedge. We go into the currency futures market and BUY August Pesos today. We are now long in the market, and "hedged". When August comes, if the actual pesos cost us more, we can offset the loss with our market profit. Inversely, if the pesos cost us less than we expected, we take that savings to pay off our market loss.

On the sell side currency hedge, lets say for example you are the Tequila Manufacturer, and you happen to accept payment in dollars. Then you HAVE dollars coming - the same way the farmer has corn coming, so you would use a SELL HEDGE like the farmer.

The trick to understanding the hedge is to ask yourself, do I HAVE IT LIKE THE FARMER (SELL HEDGE), or do I NEED ITLIKE THE IMPORTER (BUY HEDGE.)

HAVE IT is a sell Hedge (A farmer has corn. A fund Manager HAS stocks)

NEED IT is a Buy Hedge (A Jeweler NEEDS gold to make an order. An importer needs yen.) etc.