What it calculates

FX hedging quantifies the exposure created when you earn revenue or pay costs in a currency other than your reporting one, and shows what a forward contract or option overlay does to that exposure. It separates the operating result from the currency result.

How it is calculated

Net exposure is the difference between inflows and outflows in each foreign currency over a period - natural offsets reduce the amount that actually needs hedging. Forward rates come from interest rate parity: the spot rate adjusted by the interest differential between the two currencies, which is why a forward is not a forecast. The hedged outcome is the hedged portion at the contracted rate plus the unhedged remainder at whatever spot turns out to be.

How to read the result

The goal of hedging is not to profit but to narrow the distribution of outcomes. Judge a programme by the variance it removes, not by whether the forward beat spot after the fact. A hedge that loses money in a year when the currency moved your way did its job. Watch the hedge ratio: hedging everything is expensive and removes upside, and hedging nothing leaves earnings hostage to a rate you do not control.

Worked example

You expect to receive 10,000,000 EUR in twelve months and report in USD. Spot is 1.0850. With USD rates at 4.5% and EUR at 3.0%, the 12-month forward is roughly 1.0850 x 1.045 / 1.030 = 1.1008. Hedging 70% locks 7,000,000 EUR at 1.1008, or 7,705,600 USD, and leaves 3,000,000 EUR floating.

Common questions

Is a forward rate a prediction of the future spot rate?

No. It is arithmetic derived from the interest rate differential. If it were a prediction and it were reliable, you could borrow in one currency, lend in the other and take the difference risk-free. Forwards are priced to remove exactly that opportunity.

Forwards or options?

A forward is free to enter and fixes the rate in both directions, so you give up favourable moves. An option costs a premium but only caps the downside. Forwards suit committed, high-certainty exposures; options suit exposures that may not materialise, such as a bid you might not win.

What is natural hedging?

Matching foreign-currency costs against foreign-currency revenue so the exposures cancel before any financial instrument is involved. Sourcing in the same currency you sell in is the cheapest hedge available, because it has no premium and no counterparty.