3.1.2.1. Hedging and Cross Hedging
To hedge against the risk of volatile exchange rates, an importer or other investor must first determine the required hedge ratio. With respect to foreign exchange, this is a simple matter of dividing the amount of local currency you have at risk by the size of the exchange contract. A wine importer who has agreed to purchase €500,000 worth of French wine to be delivered in 60 days will hedge that purchase -with 4 Euro futures contracts, since each euro contract is worth €125,000.
hedge ratio = 4
Exporters generally like to do business in their own currency, so it is the importer that usually faces foreign exchange risk. For instance, typically, a French cheese exporter will be paid in the euro, while a French car dealer who imports Japanese cars will need to pay for them with the yen. To hedge this risk, importers will buy FX yen futures. This is because they fear the foreign currency will strengthen in the intervening months before they are required to purchase the foreign currency. If the foreign currency strengthens, the local currency will weaken, making the foreign currency more costly to buy. This is a problem for the importer because he must pay for his goods (or the price to produce goods) in the foreign currency.
Example: A U.S. importer contracts for a shipment of French wine to be delivered in three months valued at €375,000. The cash price for euros is currently $1.1210, and the futures contract is selling at $1.1254. Fearing a strengthening of the euro and a weakening of the dollar, the importer buys three futures contracts (€375,000 / €125,000 = 3). The euro does indeed strengthen, with the spot price rising to $1.1215 and the futures contract to $1.1262. The importer now must pay more dollars to get the same number of euros. But the futures rate has also increased. The euro futures he bought can now be sold at a higher dollar price. The profit he makes by offsetting the fu