| December 03, 2020
Currency Exchange Hedging Strategies x Trading?
Currency Hedging Strategies
A 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.
There 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 transaction risk.
Whereas 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.
To 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?
In foreign currency hedging, there is a set of financial contracts or agreement means to exchange currency at the fixed price. Some necessary and dynamic strategies are:
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 flows.
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 future.
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.
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.
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.
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.
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.