Hedging Currency Risk
If you are dealing with foreign currency, you need to know about hedging currency risks. In this article we will explain what hedging currency risk means. We will then look at various types of common hedging techniques.
What is hedging currency risk?
Let us examine the three words in the statement:
- Currency: It is the money you are dealing with e.g. Dollars, Euro etc.
- Risk: It pertains to the dangers that may cause harm
- Hedging: It is the act of protecting oneself by negating or dodging
Hedging Currency Risk is the attempt to insulate oneself from the effects of currency fluctuations. If you are a business you look to ensure that the value you will receive for your goods or services is maintained. If you are a Forex Trader, you will ensure that you do not incur losses.
The common currency risks
The common currency risks are:
- Exchange risks – This is the risk when you exchange from one currency to another
- Interest rate risks – Each currency normally has its own interest rates. You need to ensure you are not paying more than you should.
- Foreign exchange valuation exposure – While you are in possession of the currency, its valuation against other currencies keeps changing. It can happen that you lose value while the currency is in your possession. Forex Traders actually count on this phenomenon to make money.
The common hedging techniques
There are proven strategies that help in negating the above mentioned risks:-
Leading and lagging hedging strategies
In a business you have bills that you need to pay. If you are expecting the home currency to lose value, pay the bill in advance (leading). If you expect the home currency to appreciate, then delay the payments to a point where you do not have to pay penalty (lagging). The complete Forex Trading is based on this idea. You buy currency when low and sell it when it appreciates.
Forward Transactions
Forward transactions are done mainly in business which anticipates currency fluctuations. With this strategy, both parties agree to the value of the currency being exchanged, irrespective of the value it may have at any date in the future.
Currency Futures
This hedging is similar to forward transactions. Here, instead of fixing the rate of the goods and services, we actually lock the rate of the currency in the future and buy it. Currency futures are exchange traded. There is no counter-party risk involved. Currency futures are favoured because they are transparent in price and relatively easily available.
Currency Options
Currency options are also another favoured way of hedging. It allows the owner of the currency to buy or sell at a fixed rate. The rate is predetermined and the owner is not obliged to execute the trade. In technical terms, a call option gives the owner a right to buy while a put option gives the owner a right to sell.
Summary
All businesses, especially Forex Traders, dealing with foreign currency should learn about hedging currency risks. There are many other hedging strategies. A lot of them are newer strategies, created to suit the modern styles of trading. After all, hedging currency risks means insulating yourself from the volatility of the currency valuations.
