Devoted to understanding the basics and fundamentals of investing

Last time I talked about hedging profits.  I would like to write about hedging expenses.  Several years ago when I was the International Cash Manager for a large multinational not-for-profit corporation we needed to build a very expensive building in England.  Our budget office was concerned at how they would ensure that the building would come in within their US dollar (USD) budget when all the expenses were in Pounds Sterling (GBP).

Since the project was a multi-year, multi-million dollar project we decided that we would buy GBPs three years forward for the entire cost of the building.  No money changes hands up front in a forward contract, you settle at the forward contract date.  That would lock in our dollar cost up front.  We would buy GBP in the spot market (2 day settlement - the standard for FX trades) as we needed to fund the project and would sell off the corresponding piece of the forward contract.

If the GBP had appreciated against the dollar, we would lose money on the spot contract, i.e. the project would cost more GBP than we had budgeted.  But, we would have a gain on the forward contract that would exactly offset the loss in the spot market.  By selling off the piece of the forward contract, we would have realized gains and losses to offset each other.

If the GBP had depreciated against the dollar over the expenditure period, we would gain money on the spot contract and lose the same amount on the forward contract.  And our budget team would be happy because they would not have to worry about FX as a possible reason for not meeting their expense budget.

I hope this helps you protect your money.