The cover exchange is a mechanism that allows the investor or company protect itself from the volatility of currency . For this, a future transaction is carried out, setting the price of the currency here. In English it is known as currency hedge.
The objective of this kind of financial coverage is to guarantee the acquisition of a currency at a previously agreed rate. Thus, even if the exchange rate goes up, the buyer will not be affected.
Exchange coverage is useful especially for companies linked to foreign trade . This, because they are exposed to currency risk. That is, they can invoice in euros, but they need to pay their suppliers, for example, in dollars.
Exchange coverage tools
The main exchange hedging tools are:
- Forwardcontracts : It is a private agreement to buy and sell a currency in the future setting the exchange rate today . The amount of the operation is established and the date on which it will be specified.
- Options: They are similar to forwards. The difference is that they do not represent an obligation, but a right to acquire an asset (which in this case would be foreign exchange). This, at a price previously established and in exchange for the payment of a premium by the buyer.
- Swap: A currency swap is the exchange of one loan for another in a different currency. Both credits must be equivalent in amount and duration. The exchange may be principal, interest or both. Suppose that an English company requires dollars. Then, you can issue a bond in that currency and exchange it for another similar debt instrument called in pounds sterling. This may be owned, for example, by an American company.
In this way, the British firm will have to pay interest to the creditors of its North American counterpart, but this obligation is in pounds sterling. Thus, the exchange risk is reduced.
Finally, at the end of the financing period, both companies exchange the initial amount of the debt issued.
Example of exchange coverage
Let’s look at the case of a Spanish importer who needs $ 100 to cancel a supplier in three months. To acquire that amount of US currency, the company can opt for a forward contract , setting an exchange rate of 0.8 euros at ninety days.
Then, after that period, you will buy US $ 100 paying 80 euros, although the US currency has risen to 0.9 euros per dollar.