# Hedging using Forwards

Consider an American company which exports to United Kingdom. The UK company pays in pounds, and the exchange rates varies from \$1.4/pound (1.4 dollars per pound) to \$1.6/pound (1.6 dollars per pound). The American company will receive 1 billion pounds the next year. This variability in the exchange rates mean the company is exposed to some extra risk. For example, if the next year (when the company will receive the cash):

Exchange Rate: \$1.4/pound

The company will receive \$1.4 (1 billion) = \$1.4 billion

And, if the exchange rate at that time is:

Exchange Rate: \$1.6/pound

The company will receive \$1.6 (1 billion) = \$1.6 billion

So, there is huge difference between these two figures, and the company would definitely wants to hedge its risk. The company can hedge its risk by entering a forward contract (for example with a bank) to exchange 1 billion pounds into dollars at an agreed rate to hedge its risk. In this way any gain/loss from one transaction would be offset by loss/gain by another transaction.

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