Example

A fund manager has a fund denominated in Sterling but purchases an asset in US Dollar. If left unhedged, the fluctuation of exchange rates will affect the value of that asset in the portfolio.

USD $100.00 x 1.6 = GBP £62.50

If the exchange rate rises to 1.7, the GBP value in fund reduces to GBP £58.82.

If the exchange rate falls to 1.5, the GBP value in fund rises to £66.66.

The fund manager enters into a foreign currency forward, a type of derivative, and locks in the future exchange rate in three months to 1.6.

If the exchange rate rises during this period to 1.9, the GBP value in fund will remain at £62.50, whereas unhedged the value would drop to £52.63. This would have resulted in a loss of £9.87.

If the exchange rate falls during this period to 1.4, the GBP value in the fund will remain at £62.50, whereas unhedged the value would have risen to £71.43. This would have resulted in a gain of £8.93.

The effects of exchange rate fluctuations have been neutralised in the fund. There is a cost for entering into the derivative contract, which would need to be considered, however the fund is exposed only to the rise and fall in the price of that asset.