Hedging in Currency (Forex) Market

What is Hedging?

• Currency hedging is the act of entering into a financial contract in order to protect against unexpected, expected or anticipated changes in currency exchange rates. Currency hedging is used by financial investors and businesses to eliminate risks they encounter when conducting business internationally. 

• Hedging can be accomplished by purchasing different types of contracts that are designed to achieve specific goals. These goals are based on the level of risk the customer is exposed to and seeking protection from and allow the individual to lock in future rates without affecting, to a great extent, their Market Liquidity.

Methods of Hedging Currency Trades 

1. Spot contracts
2. Foreign currency options

• Spot contracts are essentially the regular type of trade that is made by a retail Forex trader. Because spot contracts have a very short-term delivery date (two days), they are not the most effective currency hedging strategy. 

• Foreign currency options, however are one of the most popular methods of currency hedging. As with options on other types of securities, the foreign currency option gives the purchaser the right, but not the obligation, to buy or sell the currency pair at a particular exchange rate at some time in the future.

Forex Hedging Strategy 

A Forex hedging strategy is developed in four parts, including an analysis of the Forex trader's risk exposure, risk tolerance and preference of strategy. These components make up the Forex hedge:

• Analyze risk: The trader must identify what types of risks he is taking in the current or proposed position. From there, the trader must identify what the implications could be of taking on this risk un-hedged, and determine whether the risk is high or low in the current Forex currency market. Right analysis of risk is essential.

• Determine risk tolerance: In this step, the trader uses their own risk tolerance levels, to determine how much of the position's risk needs to be hedged. No trade will ever have zero risk; it is up to the trader to determine the level of risk they are willing to take, and how much they are willing to pay to remove the excess risks. So, this level is dependent on the risk factor.

• Determine Forex hedging strategy: If using foreign currency options to hedge the risk of the currency trade, the trader must determine which strategy is the most cost effective.

• Implement and monitor the strategy: By making sure that the strategy works the way it should, risk will stay minimized and never cause any dramatic problems.

The Forex currency trading market is a risky one, and hedging is just one way that a trader can help to minimize the amount of risk they take on.