Final answer:
To hedge its FX risk without locking a position, a U.S. exporter should use an options contract, specifically a put option, to limit risk to the cost of the premium while maintaining flexibility. This derivative tool provides the right to sell at a predetermined rate, offering protection against currency depreciation without an obligation to execute the contract. Currency hedging through such financial contracts allows firms to manage exchange rate fluctuations effectively.
Step-by-step explanation:
If a U.S. exporter has a sale for $2MM CAD and wants to hedge against the foreign exchange (FX) risk without locking in a position, the best derivative to use would be an options contract. Unlike futures or forwards, which obligate the holder to buy or sell the asset at a set price on a specific date, an options contract gives the holder the right, but not the obligation, to buy or sell a currency at a certain price on or before a certain date. This provides flexibility and limits the risk to the cost of the options premium. The U.S. company can protect itself against the risk of the Canadian dollar depreciating by purchasing a put option, which would allow it to sell Canadian dollars at a predetermined rate. If the CAD depreciates, the company can exercise the option and sell CAD at the higher contracted rate; if the CAD appreciates, the firm can let the option expire and sell CAD at the higher market rate, only losing out on the premium paid for the option.
To understand the mechanics of currency hedging, consider a U.S. firm exporting to France and expecting to receive 1 million euros one year from now. If the firm wants to know for sure what the future contract will be worth in U.S. dollars, it can enter a financial contract to lock in a specific exchange rate one year from now. By doing this, the company ensures that it is protected if the exchange rate moves unfavorably, at the expense of a hedging fee. Finance institutions, such as banks or brokers, typically facilitate these contracts and earn money through fees or by creating a spread in the exchange rates.
In the context of international trade, the process of arbitrage helps to align prices and exchange rates over time. For instance, if a U.S. dollar is worth $1.30 in Canadian currency, goods will eventually be priced similarly in both countries to prevent profit from cross-border buying and selling due to currency exchange disparities.