When two parties agree to exchange currency for a specific future date, a Forward Foreign Exchange occurs. Exchange rates decided for such transactions are called forward exchange rates. In such transactions, both parties agree to a specific exchange rate, and follow that rate in the pre-decided future date for transaction. Foreign exchange rates are generally agreed for 30, 60 or 180 days and in some cases several years.
Volkswagen is Europe’s largest car maker. Many multinational companies like Volkswagen do hedging of their international currencies to minimize their risk of adverse exchange rates. Generally, Volkswagen hedges about 70% of their international currency. But, in 2003, Volkswagen decided to hedge only 30% of their currency against the US Dollar. Volkswagen manufactures its cars in Europe and exports to US. One of their best-selling models Jetta costs about €14000 to make in Germany and sells for $15000 in US. At the time of manufacturing the Euro to Dollar value was 1 to 1. So with the then current exchange rate, Jetta made Volkswagen about $1000 or €1000 profit per car.
During the year 2003, there was a sharp rise in Euro against Dollar. Earlier which was €1=$1, now in 2003 being traded as €1=$1.25. So, each dollar earned will now only profit €0.80 which squeezed Volkswagen. At the exchange rate of €1=$1.25, Volkswagen only gets €12000 per Jetta sold, that to say Volkswagen lost €2000 per car sold in the US. Unfortunately, Volkswagen only had 30% of their currency hedged to €1=$1 price. This drastic increase in Euro value caused a major drop in operating profit of Volkswagen and its fourth quarter profits drop 95 percent to mere €50 million.
Traditionally Volkswagen had hedged 70% of their currencies. In that case, they wouldn’t have lost such a huge operating profit due to the exchange rates hike. Strategy to buying forward guarantees that at some future point, Volkswagen would be able to exchange its US earned dollars in to Euros at the Pre-Determined rates of €1=$1, regardless of what the current exchange price is. In case of depreciation in the price of Euro, Volkswagen would have made more profits by hedging less of its currency which seems the case being anticipated.
Hedging is also costly as the foreign exchange dealers will charge a high commission for forward currency selling, but after such a huge loss in their profit, Volkswagen decided to get back to its historic hedging of 70% of its foreign currency.