I've put on a trade involving securities denominated in both Canadian and U.S. dollars. In addition to the risk profiles of the underlying securities, the trade is also susceptible to exchange rate fluctuations: in this case, even if the underlyings move in my favor, any trading profits would disappear if the USD:CAD exchange rate dropped from today's ~76% to ~74% (though my profit would RISE by the same degree if the rate rose to ~78%) My original plan had simply been to ignore the currency risk altogether, reasoning that it's a fool's errand to try and predict the direction of FX movement, so because the benefits I'd reap if the rate moved in 1 direction are equal to the losses I'd sustain if it moved against me, then I'll just roll the dice. IOW, if it's a +EV trade, then as long as I'm willing to bear the FX risk, I should be willing to put it on, hedge or no hedge. HOWEVER,I'd now like to understand just what it would cost to hedge / insure against the FX rate moving against me. To give an example in grossly simplistic terms, if I calculate that my trade has a current expected value of a +$1,000 gain -- which would decrease to ZERO if the CAD/USD rate dropped from 76% to 74%, but INCREASE to $2,000 if the rate rose to 78% -- I want to learn what instruments would help me 'lock in' today's exchange rate for the duration of the trade, trading away some +EV for certainty. I.e. what currency instruments would let me essentially say "I've got a net present value gain of $1,000 that's susceptible the FX fluctuations, but I'd take $800 to remove that risk altogether"? Hope this Q made sense
We need a timeframe. Uv got 2 choices. 1 Futures, 2 Options, Now a futures contract would be the ideal hedge, pretty much perfectly matching the exchange rate. Problem mbey for you would be the margin requirements if the market moves against your trade say 10c for the duration of your trade and you have a future position open you would be required to have the $ on hand to cover margin. With options, they arn't the most ideal for hedging because of the premium. Now if FX moves against you, you won't be required to pay any margin at all. So you could profit from both your trade going in your favor plus FX moving in your favor. Proving the market does this of course. You will have to pay for this privilege tho.
The instrument which is used in the institutional context for these purposes is known as a cross-currency basis swap. It's likely not available in your context, so you will need to do something else. As mentioned by the previous poster, you can choose to trade FX forwards (or its exchange-traded counterparts, FX futures) or FX option (which are options on FX forwards). Obviously, also as mentioned by the other poster, working capital would be required to do any of these things, including options.
Assuming the actual cash flow whose sensitivity needs hedging occurs in the future, spot wouldn't be the right instrument.
Q: What's best way for me to lock in today's exchange rate to hedge FX risk on a trade? A: To lock in todays exchange rate you BUY the currency. It's as simple as that.