Global companies are always exposed to the risk of price changes. Whether this risk is associated with their exports and imports or with the changing prices of commodities. Hedging against foreign exchange risk is one of the most common hedging tools used. This is because companies that mostly deal with exports and imports from different areas around the world are exposed to volatile currency exchange rates. When a company deals with long-term import or export contracts, it becomes risky to make payments in a foreign currency. If the rate of that currency drops before the payment is thru, the corporation may endure a large loss.
Lets take an example of a car dealership that imports cars from Europe, Japan and South Korea. All countries deal with different currencies that rates change daily with the dollar rate. Lets say the US company imports 100 BMW cars every 3 months from Germany at a price of 40,000 euros each. This means the total net wroth of the imported cars is 4,000,000 euros. The dealership must pay the German manufacturer in Euros. However, how much should the dealership exchange dollars to euros? The price depends on euro daily prices. In order for the dealership to maintain a stable price or at least reduce the risk since it is a long term contract, it should hedge. Hedging against foreign exchange can be done through short-term contracts “spot” or long-term contracts “derivatives”, which decreases the exposure to this type of risk.
Another example of hedging against commodity risk is fuel hedging. Fuel is a commodity that is affected generally by supply, demand, gas production levels…etc. Although we as small consumers do not feel this change, airline companies are highly affected. Large fuel consuming companies such as airline companies’, need to hedge as a protection against volatile fuel prices. As explained in the video below, Airline companies’ cost is from fuel itself. Because airlines know how many tickets they will sell in advance depending on the season and holidays they manage price risk in fuel by hedging fuel prices relative to the rates they want to charge clients.