Currency hedging: Here’s how it works and why it’s so important to so many companies and investors

Nick Sundich Nick Sundich, May 25, 2023

You’ll commonly hear the term ‘currency hedging’. It is undertaken by many companies as part of the ordinary course of doing business and even by some professional investors. Just what is it?

 

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What is currency hedging?

Currency hedging is a process of protecting against exchange rate risk, which refers to the possibility of incurring losses due to changes in the value of one currency in relation to another. By using currency hedging, investors can protect themselves from the volatility of foreign exchange markets and reduce their exposure to potential losses.

There are several methods by which an investor can hedge their currency risk, such as forward contracts, futures contracts, options or swaps. Forward contracts involve two parties agreeing to buy or sell a set amount of a particular currency at an agreed upon price at a predefined time in the future. Futures contracts also involve two parties agreeing to buy or sell a set amount of a particular currency at an agreed-upon price, but the settlement date is standardized and occurs on specific dates over the course of a year.

Options provide buyers with the right (but not the obligation) to purchase or sell a certain amount of foreign currency; however, they often come with higher transaction costs than other hedging strategies. Swaps involve swapping payments in one currency for payments in another over time and are often used when dealing with long-term exposures to foreign currencies.

 

It can be done directly or indirectly

In addition, there are various investment vehicles available that allow investors to access different types of hedging strategies without having to directly enter into any kind of contract with another party. These include trading funds that track specific baskets of currencies and exchange traded funds (ETFs), which invest in stocks and bonds denominated in different currencies.

Regardless of what strategy is used, investors should understand how each method works before taking any action and be aware that these strategies may come with certain risks, separate from the general risks of forex trading generally.

It is important for them to analyse their own financial situation and create realistic expectations regarding what level of protection they will receive from hedging strategies before investing their money.

 

What are the risks?

The risks of currency hedging can be significant and costly if not managed correctly.

The main risk associated with currency hedging is the potential for losses stemming from incorrect assumptions about the future direction of exchange rates or other market factors. For example, if a company locks in an exchange rate that proves to be unfavorable later on, the company could suffer major losses. Another risk is the cost of hedging itself, which includes transaction fees and possibly interest payments if borrowing is part of the hedging strategy.

Additionally, there are potential liquidity risks when using derivatives such as forward contracts or options to hedge against foreign exchange rate exposure.

Finally, there is also a risk that the hedging strategy may prove inadequate and fail to protect against adverse exchange rate movements.

 

So should I consider it?

As is the case with any asset class, it is important to consider all of the potential risks and rewards. Ultimately, we think there are better options for most retail investors. But if you’re in business you may have no choice but do engage in it and may be astute enough to make these decisions for yourself.

There are many reasons why investors might want to consider currency hedging, including reducing the effects of exchange rate volatility on investments, managing overall portfolio risk and protecting against unexpected changes in foreign exchange rates.

Those with portfolios heavily exposed to foreign currencies may be especially vulnerable to significant losses when exchange rates move unexpectedly, and so a currency hedging strategy could be beneficial.

It’s also important to note that while currency hedging has the potential to reduce risk, it also comes with additional costs such as transaction fees and other related expenses, so it’s important for investors to carefully weigh these factors before deciding whether or not they should pursue this strategy.

Additionally, investors should keep in mind that there is no guarantee that any given hedge will be successful in protecting against losses due to unanticipated movements in exchange rates.

Ultimately, whether or not an investor should consider currency hedging depends largely on their individual circumstances and goals.

 

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