Lesson 6.1 showed that an adverse currency move between order confirmation and payment can shrink a factory's real local-currency margin, even though the buyer's fixed foreign-currency price never changes. A factory is not left to simply hope the rate moves in its favour. Several standard, widely used methods exist to reduce this exposure before it becomes a loss: locking in a rate in advance, matching foreign-currency income to foreign-currency costs, and shortening the time between confirmation and payment. This lesson mainly teaches the decision flow: which method to reach for, and when, on a confirmed foreign-currency order.
You need: lesson 6.1's own worked example of an adverse currency move shrinking Order A's real margin, and the illustrative rate of 30 local-currency-units per USD used there.
By the end of this lesson you can:
Not covered here: what a bank guarantee costs to hold (lesson 6.3) and building a complete financial risk sheet for a new order (lesson 6.4).
| Term | Meaning |
|---|---|
| Forward contract | An agreement with a bank to exchange a fixed amount of foreign currency for local currency at a rate agreed today, on a future date. |
| Natural hedge | Matching a factory's own foreign-currency income to a real foreign-currency cost it already has, so a currency move affects both sides in the same direction. |
| Open position | An amount of foreign-currency income or cost with no forward contract or natural hedge covering it, still exposed to a currency move. |
| Hedge | Any action a factory takes, before payment, to reduce its own exposure to a currency move. |
| Spot rate | The exchange rate available for converting currency immediately, on the day of the conversion itself. |
| Illustrative exchange rate | A clearly labelled example rate used to teach a calculation, never a real current market rate for any real currency pair. |
A forward contract fixes, today, the rate at which a future foreign-currency payment will convert into local currency, removing the uncertainty a currency move would otherwise create, in exchange for a small bank fee. A natural hedge works differently: if a factory already has a real cost payable in the same foreign currency, for example an imported fabric or accessory bought in USD, using the USD income to pay that USD cost directly removes the need to convert at all for that portion. Shortening the time between confirmation and payment, for example by asking for a shorter credit period, reduces the window in which a rate can move, without removing the exposure entirely. Doing nothing leaves the whole amount as an open position, fully exposed to whichever way the rate moves.
| What can differ | The shapes you will meet | Why it matters to you |
|---|---|---|
| Whether a real foreign-currency cost already exists | Delta Garments buys most of Order A's fabric locally, so little of its own cost is naturally in USD. A different order using imported yarn or trims bought in USD could use a natural hedge for that portion. | A natural hedge only works where a real matching cost already exists; it cannot be invented to cover an order with no foreign-currency cost of its own. |
| Order size and whether a forward contract is worth its own fee | A forward contract on Order A's full USD 48,000 (3.20 x 15,000) may be worth its small bank fee, given the exposure it removes. A very small reorder may not justify the same fee relative to its own size. | The larger the exposure, the more a forward contract's fee is worth paying relative to the risk it removes. |
| Who arranges the hedge | Delta Garments can arrange its own forward contract directly with its bank. Meridian Sourcing, the agent handling a European buyer's order, sometimes advises a smaller factory on which method fits its own order, without itself taking on the currency risk. | The decision belongs to whoever holds the foreign-currency exposure, factory or agent-advised factory, not to the buyer, who is unaffected either way. |
| Domestic sale, for comparison | Cedar & Co.'s own domestic purchase from Delta Garments is priced and paid entirely in local currency, so none of these three methods applies; there is no exposure to reduce. | Recognising an order with no FX exposure at all avoids applying a hedge, and its fee, where none is needed. |
Meridian Sourcing, the agent who helped place a similar order with a European buyer, reviews Order A's own timeline with Delta Garments: 16 weeks from confirmation to shipment, with payment following under Northline Apparel's own agreed terms. Given the size of the exposure, the full USD 48,000 due on the order, Meridian Sourcing recommends Delta Garments ask its own bank for a forward contract locking in today's illustrative rate of 30 local-currency-units per USD for the expected payment date, rather than leave the whole amount as an open position exposed to whatever rate applies months later.
The worked numberA factory that never arranges a forward contract and has no matching foreign-currency cost to hedge naturally has not avoided a decision; it has made one, to accept the full open position and whatever rate applies on payment day. A forward contract's own fee can feel like an avoidable cost next to a rate that might move favourably instead. But an adverse move of the size worked through in lesson 6.1 can remove most of an order's planned local-currency profit, while a forward contract's fee is a small, known cost paid in exchange for removing that uncertainty entirely.
Once Delta Garments knows a currency move can shrink its own real profit on an order like Order A, it has choices, not just hope. It can ask its bank to lock in today's rate for the future payment date with a forward contract, paying a small fee to remove the uncertainty. If it already has a real cost payable in the same foreign currency, it can use the incoming payment to cover that cost directly, a natural hedge, instead of converting both separately. Or it can shorten the time between confirmation and payment, leaving less time for the rate to move. Doing nothing is also a choice, one that leaves the whole amount open to however the rate moves.
Delta Garments' owner reviews Meridian Sourcing's recommendation to book a forward contract on Order A's full USD 48,000, locking in the illustrative rate of 30. The bank's fee for the contract is small relative to the order, but the owner asks whether it might be cheaper to simply wait and see how the rate moves.
Here is the note Meridian Sourcing sent:
Should Delta Garments skip the forward contract to save the bank's fee? Decide before opening the answer.
No, skipping the contract is not the safer choice, once the size of the possible loss is weighed against the size of the fee. Two facts decide this together.
First, the forward contract's fee is small and known in advance. A bank's fee for a forward contract is a modest, fixed percentage of the amount hedged, payable regardless of which way the rate later moves.
Second, an unhedged position can lose far more than that fee. Lesson 6.1 already showed that an illustrative adverse move of 5% costs Delta Garments 72,000 local-currency-units against its plan on this exact order, an amount many times larger than a typical forward contract fee.
The owner's instinct to question an extra cost is reasonable, but comparing a small, certain fee against a much larger, uncertain possible loss favours booking the contract, not skipping it.
Framed on Order A's own figures, a forward contract's fee is a small, known cost against a possible loss of 72,000 local-currency-units, the shortfall an illustrative adverse move of 5% already produced in lesson 6.1.
An illustrative forward contract fee of about 4,320 local-currency-units removes exposure to a possible loss more than sixteen times its own size.
Open the Financial risk sheet workbook linked below. Reuse its "FX exposure" sheet from lesson 6.1: fill in an illustrative locked-in rate in place of the adverse rate to see the local-currency value a forward contract would protect, then compare it with the unhedged value already calculated there.
[Download the Financial risk sheet](../../templates/T15-C06-financial-risk-sheet.xlsx)
1. Delta Garments has no real cost payable in USD on Order A. Which exposure-reduction method is available to it here?
2. Why is leaving Order A's USD 48,000 unhedged not a neutral, cost-free choice?
3. A different order is worth USD 20,000, illustrative rate 40 today. A forward contract fee is an illustrative 0.3% of the hedged local-currency amount. What is the fee?
| EN | AR | FR | TR | Meaning |
|---|---|---|---|---|
| Forward contract | عقد آجل | Contrat à terme | Forward sözleşme | An agreement with a bank to exchange a fixed amount of foreign currency for local currency at a rate agreed today, on a future date. |
| Natural hedge | التحوط الطبيعي | Couverture naturelle | Doğal hedge | Matching a factory's own foreign-currency income to a real foreign-currency cost it already has, so a currency move affects both sides in the same direction. |
| Open position | مركز مفتوح | Position ouverte | Açık pozisyon | An amount of foreign-currency income or cost with no forward contract or natural hedge covering it, still exposed to a currency move. |
| Hedge | تحوط | Couverture | Hedge | Any action a factory takes, before payment, to reduce its own exposure to a currency move. |
| Spot rate | سعر الصرف الفوري | Cours au comptant | Spot kur | The exchange rate available for converting currency immediately, on the day of the conversion itself. |
| Illustrative exchange rate | سعر صرف افتراضي | Taux de change illustratif | Gösterge niteliğinde döviz kuru | A clearly labelled example rate used to teach a calculation, never a real current market rate for any real currency pair. |
You now know the main ways Delta Garments can reduce its own exposure to a currency move on an order like Order A. The next lesson turns to a different kind of financial risk instrument: the bank guarantee, and what it costs a factory to hold one open. Back to the course map