Hedging is a way to limit currency exposure by taking a position in an asset that rises and falls, thus protecting the asset from loss. However, by taking a position, it also eliminates the possibility of a gain.
A forward contract is one method of hedging. In a forward contract, the foreign currency exchange rate is locked in for a specified date. The exchange rate is set at the time of the contract, but payment and delivery are not made until the contract maturity. For example, if the 90-day forward rate for yen is Ñ120/$, no money is exchange today, but in 90 days you can buy Ñ120 for $1.
Because a forward contract has a set exchange rate, your currency exposure is definedùi.e., you can manage your cash flow using the defined rate and thus are not subject to spot rate fluctuations. In the above example, a forward contract is a good option if, in 90 days the spot rate is <Ñ120/$--meaning that in 90 days you would get less than Ñ120 for the same $1, essentially protecting your cash from currency exchange loss. If, however, the spot rate in 90 days is >Ñ120/$, then you will not benefit from the gain of receiving more than Ñ120 for the same $1 had you exchanged at the spot rate.
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