Why Do Some Firms Engage in Currency Trading?
There are two reasons firms and individuals engage in currency trading: hedging and speculation. Any firm selling goods or services overseas is exposed to currency risk. Currency values change from one moment to the next. A firm may agree to provide a product for a certain price, but if the value of the dollar rises or falls before delivery of the product, the firm will receive more or less than the agreed upon price due to the currency fluctuation. Hedging is the process of offsetting negative fluctuations in currency values.
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Types
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The two types of currency trading are hedging and speculation. When a firm actually buys or sells a product or service internationally and wants to protect itself against a negative move in the currency specified in the contract, the firm will buy or sell a futures or option contract on the underlying currency. The net effect of the trade is zero profit and zero loss, theoretically. In other words, any loss they take on the currency trade will be offset by the greater value they receive on the sale of their product or service, and vice versa.
Speculation is the practice of attempting to profit from a currency move by trading currencies without having an international product or service to protect. In other words, speculation is simply betting on the direction of a currency move, hoping to capture a profit when the speculator is correct.
Function
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Currency trading is accomplished on the futures markets in the form of currency contracts. Generally, the contracts are denominated in units of $100,000 (USD). The advent of the Euro (EUR) eliminated many European currencies such as the French Franc, the Italian Lire and the German Deutsche Mark.
Let's say Company "A" in America is buying $100,000 worth of widgets from Company "J" in Japan. The contract is denominated in Japanese Yen. If the value of the dollar drops against the Yen, it will cost Company "A" more dollars to fulfill the contract and they will lose money. So Company "A" either goes long (buys) a Japanese Yen futures contract or goes short (sells) a U.S. dollar futures contract. If the dollar goes up in value, Company "A" loses money on the currency trade, but it costs less dollars to fulfill the widget contract, so it is a wash. If the value of the dollar drops against the Yen, Company "A" has to pay more dollars to fulfill the widget contract, but this shortfall is offset by the profits they make on the currency trade.
Time Frame
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All futures contracts have an expiration date. Currency contracts have a trading "month," and that is the month in which they expire. A firm trading currencies would buy or sell the appropriate currency contract for the month in which they are expecting to take or make delivery of their product or service.
Benefits
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Large multi-national companies will usually employ a significant currency trading staff. Becoming adept at hedging currency contracts allows a firm to continue its day to day business without worrying about currency fluctuations outside of its control. Currency trading levels the playing field for firms doing business overseas.
Warning
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Currency speculation can be extremely risky. Due to margin requirements, it is possible to lose ones entire investment and end up owing even more money. Only seasoned currency investors should speculate in currency futures.
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