Glossary

Ratio forward

Ratio forward hedging is like a safety net for businesses dealing with money in different currencies. It's a way to protect against the risk that comes from changes in exchange rates.

What is Ratio Forward Hedging?

Ratio forward hedging is like a safety net for businesses dealing with money in different currencies. It's a way to protect against the risk that comes from changes in exchange rates. Imagine you're a business that buys goods in Europe but sells them in Canada. If the value of the Euro goes up compared to the Canadian dollar, your costs go up, but your selling price doesn't. To prevent this, businesses use a strategy called ratio forward hedging. They make a deal to exchange money in the future at a rate they agree on now, but they only cover part of their money, not all of it. This way, they can protect some of their money against big changes in currency value while still having a chance to benefit if rates move in their favor.

Why Is It Important in a Business?

This strategy is crucial because it helps businesses manage their money more predictably. By hedging a portion of their foreign currency exposure, businesses can avoid unexpected losses from sudden exchange rate movements. It's like having a backup plan that keeps your expenses stable even when currency values change. This stability is essential for budgeting, planning, and maintaining profits.

How can we calculate?

Calculating the right amount to hedge involves understanding your business's currency risk and deciding how much of that risk you're comfortable with. Let's say your business expects to spend $100,000 in euros in the next six months. If you want to hedge 50% of that, you'd set up a forward contract to exchange $50,000 in euros at a predetermined rate in six months. The decision on how much to hedge depends on how much risk you want to take with currency changes. Some businesses might hedge a small amount because they think the currency will move in their favor, while others might hedge more to play it safe.

In short, ratio forward hedging is about finding the right balance for your business between protecting against risks and taking advantage of opportunities. It's a strategic choice that requires careful thought and planning.