| December 03
Currency Exchange Hedging Strategies x Trading?
concept referring to the rules and procedures adhered by the investors or
traders involved in the international business. This is followed to protect the
profit of the investors trading in the foreign currency from the fluctuations.
The currencies are volatile in value and this can pose risks to the investors,
currency traders, importers, exporters, and domestic companies that use foreign
products or services.
are primarily three risks involved when dealing with foreign currency-
transaction, translation, and economic risks. Transaction risks pose a threat
to investors, market traders, importers, and exporters. The risk of losing
profit margins because of currency appreciation or depreciation is called a
the translation risks are those which are incurred when there is an investment
in foreign assets like real estate. If the foreign currency depreciates, the
investors lose a part of its investment only because of currency translations.
The economic risk is the sensitivity of the firm’s present value of future cash
flows to the changes in exchange rates.
avoid such risks and make the cash flows more predictable, currency hedging is
followed by the investors and companies. This is not any means to make more
profit, but only a way to minimize losses. This is the reason few investors
prefer to hedge a percentage of their portfolio so that there is still room for
some additional profits (and even losses).
What are the types of strategies?
foreign currency hedging, there is a set of financial contracts or agreement
means to exchange currency at the fixed price. Some necessary and dynamic
Contract: These are the most commonly used contract between the parties
involved in hedging. The financial agreement which allows the counter party
to exchange a fixed quantity at the pre-defined rates after a specified
time. This helps in locking the currency rates and prevents future cash
Contract: These are the standardized contract, which works similarly as
the forward contract. They are more liquid as they are traded on stock
market exchanges, unlike over-the-counter trades. One can easily hedge the
depreciation by selling the future while appreciation by buying the
Options: These are the financial contracts that provide the holder with
the right to buy and sell the currency at a specified rate for a fixed
period. The specified rate is called the strike price, based on which the
holder can decide. The holder is provided with the right but not an
obligation to exercise the contract. If the exchange rate is in favour of
the holder, they can even skip exercising it and let it expire. To enter
this contract, there is a prepayment in the form of a premium from the
buyer to the writer.
Swaps: The financial contract that enables two parties to exchange a
series of cash flows of one currency to the series of cash flows of
another currency over a specified time. Each party is liable to pay the
interest for the exchanged currency at a regular interval of time during
the term loan.
- Foreign Debt:
This is taking a loan in the foreign currency to hedge against future
fluctuations. For example- an exporter is expected to receive a payment in
USD at a future date. If the USD depreciates, then the company has to
suffer losses purely due to currency rates. In order to protect oneself,
the company can take a loan in USD for the same period and convert that
into the domestic currency at current exchange rates. In the future date,
when the exporter receives the payment, this can be hedged by paying the
loan off in USD.
- Cross hedging:
This is done by entering into two positively correlated currencies with
opposite positions. When the currencies are positively correlated, they
move in the same direction hand in hand. It is an important technique and
used by those currencies whose hedging is not possible otherwise.
Diversification: Investing in the securities denominated in different
currencies is called currency diversification. This way a company is exposed to
the international markets along with mitigating the risks.