A common practice in international finance is hedging currency exposure, and it can be an incredibly important part of both the corporate financial and asset management worlds.

The practice of hedging is quite simple if you understand both forward and options contracts, as these are the two primary methods of hedging currency exposure risks. While they are very similar, the important difference is that forwards are an agreement to buy/sell at a future time, while options are agreements to have the ability to buy/sell at a future time. By using these derivatives, the hedge can provide a party with opposite exposure to the underlying transaction, thus eliminating currency risks.

For example, let’s imagine I buy $1 million worth of property in Japan that I want to sell in the future for $1.5 million. However, there is a risk that, in the future, when the property is worth $1.5 million at the current exchange rate, it will be worth less if the yen loses its value. Therefore, I would want to buy a derivative such as a put option on the yen that will go up in value as the yen falls.

This kind of hedging is commonly done, and the calculation of how much one needs to hedge will depend on a number of factors. In some cases (as with put options), calculating the amount to hedge can be subjective, whereas with forwards being used to hedge bonds, the calculation is much simpler. What is crucial for any hedge is understanding which derivative to use for which purpose while also understanding the risks involved (derivatives, after all, have a tendency to blow up in extreme situations).

Another issue with hedging: it isn’t free. The cost of hedging will eat into profits, and that can be a very big problem if your margins are very small. For instance, an American corporation buying goods in JPY will want to hedge the risk of JPY rising in value, but if the corporation’s marginal profit on the goods bought in JPY is equal to the cost of the hedge, the hedge will make the business untenable (although, with margins that small, the business was probably untenable on its own). Investors and corporate financiers need to be aware of the costs as well as the risks of currency exposure, and they need to be able to decide from the variety of hedges available for their unique circumstances.