So how can a business protect itself against currency volatility?

One risk management tool that can help a business protect its profits from unforeseeable changes in the currency market is hedging. The primary goal when hedging is to protect your companys profits from exchange rate uncertainty at the lowest possible cost.

How to hedge against risk exposure

Individuals and businesses can easily reduce exposure to currency risk by taking positions in the spot currency market. For example, if a US company doing business with the UK wants to protect itself against a depreciating dollar, then the appropriate hedge would be to short dollars and go long pounds in the spot currency market. By using a trading account, the business can customize the amount of leverage it uses, (all amounts up to 100:1*) so that even a perfect hedge is possible at a very low cost.

*Without proper risk management, a high degree of leverage can lead to large losses as well as gains

For instance: an American importer is expecting a shipment of 380,000 pounds sterling worth of British goods in four months. To pay his supplier, he will need to convert dollars to pounds.

Because he will not be making payment until the goods are delivered, there is a risk that the dollar may decline and make purchase more expensive. There is also a chance that it would appreciate and make the transaction cheaper, but the importer prefers to enter a hedge to avoid the risk of having to pay more in the future.

To hedge his risk, he buys 380,000 pounds in the currency market. If the pound appreciates (and consequently the dollar depreciates), he will profit in his trading account-and completely offset any losses he would have incurred by converting at the end of the four months.

Low-cost protection

Hedging can result in substantial savings. Without a hedge, a move from 1.79 to 1.93 (shown on the chart) would have meant that the importer paid $53,200 at the end of the four months! By protecting himself with a spot market trade, the importer made this $53,200 in his trading account and cancelled out the loss. The cost to make the hedge? $190.

Hedging in the spot market is a very effective and affordable way to protect against currency volatility. Since up to 100:1 leverage* is available in a trading account, relatively little initial capitalization is needed. Trades can be made over the internet, with no commissions or fees to pay, aside from the cost of the bid/ask spread. Learn more about how a trading account works.

*Without proper risk management, this high degree of leverage can lead to large losses as well as gains.

An additional source of revenue

Of course, exchange rate movements can also provide opportunities to make additional revenues by taking positions in the currency market. The same market volatility that makes hedging necessary when doing business can also be used to make up for lost revenue when currency prices make your product more expensive abroad, for example. Learn more about how trading for profit works.