Hedging

Hedging refers to the avoidance of a foreign exchange risk, or the covering of an open position. For example, the importer could borrow $100,000 at the present spot rate of SP=$2/£1 and leave this sum on deposit in a bank (to earn interest) for three months, when payment is due.

By so doing, the importer avoids the risk that spor rate in three months will be higher than today’s spot rate and that he or she would have to pay more than $200,000 for the imports. The cost of insuring against the foreign exchange risk in this way is the positive difference between the interest rate the importer has to pay on the loan of £100,000 and the lower interest rate he or she earns on the deposit of £100,000.

Similarly, the exporter could borrow £100,000 today, exchange this sum for £200,000 at today’s spor rate SR=$2/£1 , and deposit the $200,000 in a bank to earn interest. After three months , the exporter would repay the loan of £100,000 with the payment of £100,000 he or she receives.
The cost of avoiding the foreign exchange risk in this manner is, once again, equal to the positive difference between the borrowing and deposit rates of interest.