You’re selling [I]widgets[/I] in the U.S., made from parts that you buy in Britain.
If you were the only seller of widgets, then a [I]future[/I] drop in GBP/USD would be a windfall for you. But, you obviously have competition (otherwise, the question you have asked would make no sense).
Suppose:
B[/B] you lock in the cost of British parts at today’s rate, and attempt to sell the products made from those parts over the next 3 months, in the U.S. market, at a price that covers your costs and earns you a profit, but…
B[/B] sometime in the near future, your competitors, who are on a different production cycle, buy their parts at a lower price after the GBP/USD falls further, and then are able to undercut your prices in the U.S. market, because their parts prices are lower.
In this scenario, you risk either B[/B] ending up with unsold inventory, or B[/B] having to discount your products below your cost of production, just to clear out your unprofitable inventory in the face of low-price competition.
[B]This is a classic problem in forward pricing, and this is exactly the sort of problem that led to the birth of the futures industry, and the strategy called hedging.[/B]
If you can make a satisfactory profit buying parts at today’s prices, and selling finished goods at today’s prices, then you can protect yourself from the [I]currency risk[/I] you have described in your post by contracting for the parts you need now, and SHORTING the GBP/USD now.
You can short the GBP/USD in the futures market, or in the forex market.
If you choose to use the forex market, choose a broker who allows you to trade in small lot sizes — 1,000 units of GBP/USD, or smaller. That way, you can most closely match the notional value of your SHORT forex position to the contract value of the parts you need to buy.
If you need to buy £5,000 worth of parts right now (at a cost of $6,500 not counting exchange fees), then you can lock in your current profit margin by SHORTING 5,000 units of GBP/USD (that’s 5 micro-lots). Make sure that your forex account is adequately funded to cover any loss that might occur [I]if the GBP/USD heads higher.[/I]
With this hedge in place, if the GBP/USD drops to $1.15 (as you suggested in your post), then the loss you will suffer discounting your products in the U.S. retail market will be offset by an equal profit earned in the forex market.
The cost-of-carry for the 3-month duration of your hedge is probably negligible, but confirm that before you enter your GBP/USD short.
When you contract for parts at today’s price, you are essentially committing to the next 3 months of this business. But, your forex position does not commit you to any fixed time period — you can add to, reduce, or close your forex position at any time, if you change your view regarding the currency risk you are hedging.
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