There is certain amount of risks involved in hedging but they are not much. If you pay attention to the basics, these risks can be controlled. The risk occurs from the incorrectness of the prediction and can sometimes lead to unanticipated price fluctuations. Suppose a company purchases over forecasts and hedges with forwards, the profit or loss involved with the hedge will be more as compared to the variance. If you do over forecasts and the dollar strengthens then you will have to face a loss on forward contracts and vice versa if the dollar weakens. The overall profit or loss will be around the percent over forecasted times the percent that the dollar changed i.e. a 30% currency strengthening and a 40% over forecast will result in 6% extra cost of the parts.
You must buy some of the parts at the spot rate when under forecasting without a counterbalancing hedge. They will be cheaper if the dollar strengthens and more expensive if the dollar weakens. If you select the proper currency, you can surely earn great profits. If you are a good speaker, you should be able to get an initial price of 5% or may be more against an unstable currency like yen or the mark. After that, the most significant decision that you need to make is to hedge or not. If you decide not to hedge then it will let the buyer to dollar price swings that are generally 20% in six months. Majority of the companies don’t accept such type of uncertainty.
After this you need to decide upon a hedging strategy. You can choose the hedging strategy based on various statistical analyses of credible results. By choosing a hedge strategy for long time will help you save 3.6 percent as compared to pay without hedging and 1.8% compared to hedging with forwards. Buying in supplier’s currency without hedging is involves a lot of risk and buying in dollars is more risky. So you can choose from hedging with forwards or options. You can choose options if they free as they allow you to take benefit of the stronger dollar and will guard you against weaker dollar. But options are rarely available for free and they are quite costly if you buy them as compared to forwards.
If you try to examine closely the chances of the currency changes and think that the dollar will weaken then you should opt for forward contracts. They will give you the same outcome like an option but at lesser cost. Select on the basis of related cost if there is no clear trend. Options could be a better option then forwards when the dollar had no net change against the yen. Consider purchasing an option if the cost difference between option and forward contract is less than 3.5%