Let’s say that you are an American software company and are doing some custom consulting work for a company in the UK. They agree to pay you £ 1,000,000 in six months when you deliver the source code. (Great work if you can get it!)
Today the £ is trading at: $1.9438/£, this means that each £1 will get you US $1.94. This puts the value of your contract at $1,943,800. So we have seen the US dollar fall over the last few years and you want to protect yourself against fluctuations. If the dollar gains 10% for example in six months, you will get less dollars in six months when the UK company pays you. You want to lock into today's exchange rate.
There are many ways to do it, but here is a cool one. According to today’s WSJ, the UK prime rate is 5.5%. In the US, E*Trade’s 6 month CD rate is 3.38%.
So what do you do? Borrow £ and invest them in $. Here is what you do in specifics:
You know you are going to have a payment of £ 1,000,000 in six months. So take out a 6 month loan in the UK which you will pay back with your £ 1,000,000 payment.
How much of a loan? Not £ 1,000,000. But £ 1,000,000 minus the interest you will pay. You find that like this:
The UK prime rate is 5.5% per year. You will borrow for 6 months. So 5.5/2= 2.75%. (You divide by 2 since you are doing it for 6 months of ½ a year. If it was for 3 months you would divide by 4.)
Now get the 2.75% to a multiplier, so 1 + (2.75/100)= 1.0275
So £ 1,000,000 / 1.0275 = £ 973,236
So you will borrow £ 973,236. In six months you will owe £ 1,000,000.
Now take that £ 973,236 and convert it to US dollars.
£ 973,236 x $1.9438/£= $1,891,776.16
Now invest that in your E*Trade 6 month CD at 3.38% (We don’t have to divide by 2 since this is the published rate for 6 months, E*Trade did the math for us.)
Now get the 3.38% multiplier, so 1 + (3.38/100)=1.0338
In 6 months you will receive: $1,891,776.16 x 1.0338=$1,955,718.19
When you have to pay off your loan in six months in the UK, it is £ 1,000,000, just hand over your £ 1,000,000 check your customer gives you. Who cares what the £ is trading at-up or down. You also made about $12,000 over your estimate of $1,943,800 by investing the money at a higher annual rate (closer to 6% than your borrowed at 5.5%). Of course you will have to pay taxes on this amount but then again you can deduct the interest on your taxes of the UK loan!
Now, let's return in 6 months and see if the £ went up or down against the $!