Gain or Loss of Forex

If the Deutsche marks fall to $0.45, the manufacturer pays out only $450,000; however, he sells the contract for $50,000 less than what he paid for it, and the bank debits his credit line for the difference. Thus, there is no net gain, either. The forex currency exposure has been effectively hedged, and the payment is for the anticipated amount, no more, no less, whether measured in Deutsche marks or in dollars.
This example is called a "perfect hedge," which is something that is rarely attainable. The gain or loss from a hedge transaction seldom exactly offsets the gain or loss of the exchange rate move. The contract and the currency may change values at slightly different rates. Also, there are possible tax implications involving the market transaction, and there are always transaction costs to consider. Regardless, if the hedge is properly constructed, these factors are insignificant compared to the reduction in risk exposure.

Is Hedging the Answer

The above example illustrates a problem of much greater magnitude than the imprecision of offsetting gains and losses. This problem underlies all forex institute risk management programs. Simply put, should the hedge be entered in the first place? Does it benefit the manufacturer? Only hindsight reveals the answer.
If the dollar made a major advance against the Deutsche mark while the hedge was in place, it would produce a loss of major proportions. The fact that it was offset by a savings somewhere else may not be enough justification, especially when the loss, or "hedge burden" as it is sometimes known, is being explained to a senior manager who has had no input in the risk management program. This is the single biggest obstacle to forex trading currency management. Unless there are clearly defined objectives, safeguards in place, and clear communications among the various levels of management, a hedging program can end up as a non-starter at best and a financial disaster at worst.

U.S. Exchange Rate

The record is littered with casualties. In 1984, Lufthansa had placed a major purchase order for airliners from a U.S. firm. Its economists were forecasting a stronger dollar. Perhaps aware of Laker Air's experience, it locked up the
Deutschemark/dollar exchange rate with a forward contract. The economists guessed wrong. In one year, Lufthansa had lost somewhere around $150 million, and one or two financial managers reported by lost their jobs. Separately, the chairman of Porsche found himself unemployed two years later. He had engineered the company into a dependence on the U.S. money market for 61 % of its revenue without hedging against a downturn in the dollar. Porsche suffered a major financial setback as a result. It was about that same time that Volkswagen began sorting through a loss of $259 million which lined the pockets of a group of currency traders who had falsified documents in an illegal "bucket shop" operation.
Meanwhile, in the United States, Zenith Electronics Corporation was explaining concept to its stockholders a $13 million loss on a forward contract. Jerry K. Pearlman, chairman and president, remarked that "it's the kind of mistake we will never make again."4 It's a "damned if you do and damned if you don't" situation, and it's no wonder that U.S. corporate officers would just rather forget the whole thing.