Sep 29, 2011 Forex hedging is a method which is used to control any trader’s exposure to variations in foreign exchange rates. This technique helps to reduce uncertainty involved in transactions that will occur on a future date in a different currency and stabilize monetary flows as well as earnings. The system involves utilizing forward & future contracts and options to minimize losses due to forex rate fluctuations.
What hedging consists of?
Both forward as well as future contracts are useful in reducing currency risks but forward contracts are better as they provide overall risk minimization. However, forward contracts have lower liquidity, greater counter party risks and the transaction costs are also higher as there is dearth of any central market for such contracts.
Objective of hedging
The main objective of hedging is to lower uncertainties rather than increasing gains from monetary speculations. Hedged position thereby protects a business from probable losses resulting from unfavorable forex rate movements.
Hedging Strategy
The hedging strategy involves development of portfolio which includes long as well as short positions in any specific forex currency assets. This is done so that profits in one position can compensate for losses in other position. For this purpose different derivatives are used which have price movements that are correlated to movements occurring in spot market.
Normally, underlying currency is same in these derivatives which are utilized for hedging and in forex currency asset that is hedged. The reason is that price movements in both will be quite similar and serve the hedging purpose pretty well.
Functional features
In hedging forward contracts provide forex traders fixed cost for their forex currency trading as well as for purchase of foreign currency. In a situation where the forex rates are more in the foreign currency, forward contract rate is lower compared to present spot rate and helps to reduce the cost even further.
A forward contract is also used in internal transactions. If a company sells as well as purchases from a particular country then local currency purchases help to minimize effects of currency exposure on forex company. Using forward agreements in internal transactions the company is only required to hedge the difference amount.
Options are another method which lets a buyer utilize the advantage of increment in the value of any particular currency. But it is also worth noting here that these are costly. As for example, option for 6 months for somewhat volatile currency will be costing around five percent.
Hedging Risks
There are risks in hedging but these can be controlled if a forex market trader is attentive and adheres to fundamental techniques. Risks in hedging are due to forecasting errors and result in price variations. In case over forecasting of purchase is done and forward contracts are used, it could result in losses or gains which are larger compared to the variance.
Conclusion
Thus we can see that hedging is quite helpful if properly used and knowing the fundamental is important. By utilizing various hedging strategies you can minimize your risks in forex trading and increase profits.
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