Question

A US importer who owes and Belgian company 500,000 Euros payable in 30 days from today expects that the US Dollar will weaken during this period. What would you advise the importer to do? What would happen if the imported took your advice yet instead of the dollar weakening, the dollar actually strengthened?

 

Answer 1

Ques. A US importer who owes and Belgian company 500,000 Euros payable in 30 days from today expects that the US Dollar will weaken during this period. What would you advise the importer to do? What would happen if the imported took your advice yet instead of the dollar weakening, the dollar actually strengthened?

Ans. Say, the US Dollar is bearish and Euro is bullish, you sell a dollar-euro futures contract. If we assume the dollar to weaken from currently 1 euro=1.09 Dollar, to 1.19 dollar,

then 500,000*0.10 =$50,000 needs to be paid more by the US importer. This happens if dollar weakens in comparison to the euro. If the reverse happens, that is dollar strengthens then, US importer would have to pay less in dollars to clear his debt.

So when a dollar weakens, an importer will have to pay more in dollars and if it strengthens, he will have to pay less.

To minimize the loss for US importer, he should take Hedging as an option. Hedging is to minimize the risk of unpredictable changes in currency rates(here dollar/euro rate)by taking a position in the futures market. This can be done by approaching an investment bank.

This process allows both parties to lock in a particular rate at which the transaction would be done. When an investment bank or intermediary is involved, then there is a cut/commission for them also. Hedging protects them from favorable/unfavorable rate movements.

If an importer is concerned about the weakening of the US dollar and he has to buy euros in order to pay Belgium exporter, then he should go long on currency futures. This means that he should purchase a dollar/euro futures contract as a strategy of hedging. Fixed-rate now needs to be paid to exporter regardless of rate movements. So let's say the rate is fixed at 1 Euro = $1.15, then also he saving 500,000 times $0.04 when $1.19 is assumed rate after 30 days. It may happen that dollar strengthens i.e lesser dollar needs to be given by importer to Belgium exporter.

If dollar strengthened and importer hedged at a fixed rate, let's say, $1.15, then he will incur a loss. As currently 1 Euro=$1.09, if it strengthens then it would be lesser than $1.09, and then importer would have to pay more dollars in order to clear his debt of Euro 500,000.

Hedging is the double-edged sword for a party and is chosen considering the market conditions prevalent.