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

Solution:-

If the U.S $ actually weakens, the U.S importer who owes the Belgian company euro 500,000 payable 30 days from today will make a loss. It means he will have to pay more in dollars to receive the same goods or services, whereas the Belgium exporter will receive more in dollars terms for selling same goods and services. To minimize the losses the U.S importer should undertake hedging. Hedging implies taking a position in the futures market. The objective of hedging is to minimize risk associated with unpredictable changes in the dollar/euro rate. In this process, both the parties will lock in a particular dollar/euro rate so that they are not exposed to favorable as well as unfavorable exchange rate movement.

If a U.S importer has to buy Euros in future to make payment to the Belgium exporter, and he (importer) is concerned about the weakening of U.S dollar, then he should go long on currency futures, which means he should purchase a dollar/euro futures contract as a hedging strategy. The U.S importer will purchase the euro at an agreed upon rate and date to pay for merchandise to the Belgium exporter, regardless of what happens to the dollar. This will protect the importer against the weakening of the U.S dollar. On the contrary, if the US $ strengthens, the US importer could have gained from the new rate because then he would have to pay less to Belgium exporter to buy the same amount of goods and services, whereas the Belgium exporter would stand to face losses because he would receive less in terms of US dollar for the same amount of goods and services.

By hedging, therefore, both the parties can assure themselves of the payment and prevent themselves from the risk of fluctuating exchange rates in the future.