How to protect yourself against exchange rate fluctuations through hedge contracts?
- IBREI
- 1 hour ago
- 2 min read
Contributing to companies during this turbulent period caused by the coronavirus crisis, we will address how to protect against exchange rate fluctuations in import and export contracts through hedge agreements.
So-called foreign exchange derivative contracts are extremely important at this time, given the significant exchange rate volatility we have been experiencing.
In fact, by March, the Brazilian real had become the fourth most devalued currency in the world. This was influenced by government measures aimed at weakening the currency, the Russia–OPEC episode regarding oil supply, and, of course, the broader crisis related to the coronavirus.
The purpose of a hedge operation is to neutralize the exchange rate risk that a company faces in transactions involving the purchase of goods or services in foreign currency.
These contracts simulate, in a virtual environment, a currency buying and selling transaction. The parties do not actually receive foreign currency in cash; instead, they receive an equivalent amount in local currency, corresponding to the value in foreign currency based on the exchange rate difference between the contract date and the settlement date.
If you are the buyer in a derivative contract, you gain financially if the local currency depreciates at the time of payment.
If you are the seller, you benefit if the opposite occurs—if the local currency appreciates by the settlement date.
For example, an importer of goods or services prefers the foreign currency to remain stable or depreciate against the local currency. Therefore, the importer seeks protection against the depreciation of the local currency (and the risk of paying more than expected to a foreign supplier).
In such cases, the company can use the derivatives market to neutralize this risk. It must enter into a hedge operation that generates gains if the local currency depreciates. This is typically done through futures, options, or swaps involving the purchase of foreign currency. If the exchange rate moves unfavorably, the financial loss is offset by gains in the derivatives market.
In export operations, the situation is reversed. Exporters benefit when the local currency appreciates. Therefore, they use derivative contracts involving the sale of foreign currency. If the local currency depreciates, the gains from the derivatives operation compensate for potential losses in the underlying transaction.
In simple terms, this is how hedging strategies in the derivatives market help protect companies against exchange rate fluctuations.
Watch the author’s video on the subject.
Luis Felipe Dalmedico Silveira – Member of the IBREI Business Law Commission, Partner at Finocchio e Ustra Advogados
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