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Let's say you run a business in Canada exporting goods to the US. You negotiate a price with a client up front, but only get paid when you ship an order a few months later. Clients pay in USD, so it's good for you when CAD is low and bad for you when CAD is high (because your USD buys less CAD, which is what you actually use to pay workers, spend on yourself, etc.) Also let's say it's the kind of business where you ship massive orders, but only a handful of times per year.

In the months between finalizing a price and receiving the cash, you're exposed to foreign exchange risk. If CAD goes down, you end up making more money "for free", but if CAD goes up you make less. In the long run, you expect these currency fluctuations to average out; the unexpected surpluses will go towards covering unexpected losses.

Now let's look at a financial engineering trick that can eliminate this currency risk. Let's say you buy some `call` options, and sell some `put` options on a CAD/USD fund. (Selling the puts covers the cost of buying the calls). Now, if CAD goes up--which is normally bad for you--the value of your call options also goes up and cancels out your losses on the shipment. If CAD goes down--which is normally good for you--the puts that you've sold grow in value and must be settled with the buyer, so this cancels out the surplus you made on the shipment. The net result is that the amount of CAD you expect to receive two months after signing a contract in USD is "locked in" based on the exchange rate at the exact time you signed the contract and simultaneously bought the options.

So far, both the naked method and the "hedged" method result in the same expected profit in the long run. But notice that in the hedged case, you don't need to carry extra cash on hand just in case your company is hit with 3/4/5+ bad orders in a row. You don't need an insurance policy, you don't need to carry debt, and you don't need to pay the interest associated with either of those. You might still need some extra cash lying around to cover for other unexpected risks like labor strikes, natural disasters, whatever, but not for currency risk. This money is now freed up and you can use it to build new factories and grow your operation. You've made your business more efficient without lifting a finger!

Now the beautiful thing is that on the other end of this options deal there's going to be someone selling calls and buying puts that has the exact opposite problem you have. Maybe an importer in Canada or an exporter in America who both benefit from a rising CAD. They too get to lock in a price and avoid carrying extra cash to cover for currency risk. You both ended up helping each other without having to expend any effort finding the other party, negotiating deals, etc.

Now think how much more efficient the economy gets when everyone does this. And this is just one technique.


Regarding personal investment, you can likewise use hedges, levers, and other financial instruments to come up with a risk/reward profile that matches your particular life situation. As a very simple example, you can buy a "protective put" option at say 80% of the price of equity A. This basically acts as an insurance policy; you spend a bit of money on the put, but now you're guaranteed to not lose more than 20% of your investment. Why not just keep 80% of your money in a bank account and invest 20%? Well, to make the same return you'd have to find an equity B that's expected to return 5x what you're expecting from equity A, and that might not exist.

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