Foreign Exchange Hedging

Written by Jacey Harmon
Bookmark and Share

Currency markets are highly liquid. A major currency may see its price change as many as 18,000 times per day. Though price fluctuations may appear minimal, they are large when you consider the size of each trade. Leverage is an essential part of trading currencies. With leverage you can control as much as 100 times your actual capital. A fully leveraged $10,000 can control $1,000,000 in currency. A one pip move--.0001-equals $100 in either direction. As you probably sense, leverage can increase risk just as much as reward.

Protecting Yourself from Risk

Traders use hedging strategies to protect themselves from risk. A hedging strategy is simply a strategy that reduces the risks involved with trading. It most often involves two trades in opposite directions. A hedge would be if you were long and short the dollar at the same time. A trader may use a hedge to protect profits without closing out the original position.

Traders aren't the only market participants that utilize hedging strategies. International corporations utilize hedging strategies to protect themselves from adverse price movements in foreign currencies. For example, an American company purchases a lot of goods from Japan. If the Yen rises in value against the dollar, it reduces the purchasing power of the American company. If the company expects the Yen to rise they will employ a hedging strategy to protect purchasing power and profit margins.

The most common type of instrument used in corporate hedging is a currency futures contract. Currency futures guarantee a company will be able to exchange currencies some time in the future at a price determined today. If the foreign currency rises in value the company is protected by its contract position. Companies also use currency options to hedge against risk. An option contract ensures a company has the right to buy a currency at a specific price sometime in the futures. These instruments differ from futures contracts as a futures contract is an obligation to buy in the future, not a right.

Bookmark and Share