Rising trends toward the globalization of goods and services over the last few years means that more and more firms must now make decisions about their foreign exchange exposure. In addition, this need is provoked by the increasingly volatile foreign exchange markets. Exchange rate risk exists when a firm's revenues and expenses are valued in different currencies. Exchange rate risk naturally has an upside as well as a downside, but the experience of most developing countries has usually been depreciation against more stable currencies (Matsukawa). Currency hedging, or management of foreign exchange risk, is a method in which firms try to evade losses, not just on current transactions, but also on anticipated future cash flows. There are different ways a firm can 'hedge' against exchange rate risk.
Trading in each pair of currencies consists of two parts - the spot market, where payment is made right away, and the forward market.
The rate in the forward market is a price for foreign currency set at the time the transaction is agreed to but with the actual exchange taking place in the future. This pledge to exchange currencies at a later date at an agreed exchange rate is called a forward contract, and is one of the most common ways to manage exchange rate risk (Brealey 679).
Another way to hedge against foreign markets is with the use of futures contracts. Futures contracts are agreements made in the present for the purchase or sale of an asset in the future (Brealey 679). One difference between forward contracts and futures contracts is standardization. Forwards are for any amount, where futures are for standard amounts. Another difference is that forwards are traded by phone and telex and are completely independent of location or time (Brealey 679). Futures are traded in organized exchanges such...