The basic principle behind currency hedging is to exchange the currency while the rate of exchange is favorable, and then make the investment with currency that is native to the country of origin. This approach is adopted to safeguard the investor against fluctuation in currency exchange rate, and thereby preventing a monetary loss. What basically happens is that, your incomes and expenditures do not get affected by any wayward exchange rate or interest rate fluctuations.
If a trader is long on a particular currency, he will protect his downside exposure by hedging it with a perfectly offsetting short position in another market. If you're still confused, the following strategies will make the concept clearer to you.
Foreign Currency Hedging Strategies
There are various internal and external ways of hedging foreign trade risks. The internal ways are as follows:
- Leading and Lagging Income and Expenditures: A trader can lead (pay in advance) or lag (pay late) his foreign currency payments, depending on whether he expects the foreign currency to appreciate or depreciate, in the near future. The idea is that a foreign currency depreciation (home currency appreciation) translates into lower receipts and higher payments, respectively.
- Netting Receipts and Payments: The idea of netting involves matching (or clubbing) the receipts and payments in a currency, so that any losses in receipts are compensated by the gains in payments and vice versa.
Though there are several other internal strategies available to a firm, the ones mentioned above are the ones prominently used. The external strategies are more popular though, as they offer a broader scope than the internal ones. There is a limit to the amount of risk that can be hedged by the internal strategies, which the following external strategies do not possess.
This is by far the most popular means of foreign currency hedging in the world of finance, today. Forward contracts are contracts that lock in a fixed exchange rate, for the receipts and payments. This rate is usually the market determined forward exchange rate. What forward contracts do is offer stability to the receipts and payments.
Both parties (the receiver and the payer) know exactly how much needs to be paid or received and the ongoing exchange rate on the date of the transaction hardly matters. This limits the losses but also limits the extra profits that could have been made, had the rate on the transaction settlement date been more favorable than the predetermined forward rate. An equivalent hedging strategy for foreign currency risks in the commodity markets, can be achieved through futures trading.
Currency swaps are exchange transaction that take place in real-time, i.e., one thing is exchanged immediately for another, without any lapse or delay in time period. In a currency swap transaction, the principal and payments of a fixed interest contract in one currency, are swapped with the principal and payments of an equal loan in another currency. Sounds difficult but it really isn't so.
This is effectively me swapping my one currency fixed payment obligations with you for another currency fixed payment obligations, so that both of us will be dealing in the currency in which we have more faith. Thus reducing our foreign currency risk between ourselves.
Foreign Currency Options
Options are basically derivative instruments that derive their values from the underlying instruments that they represent. Currency options are thus derivatives based on foreign exchange (forex) or currency valuations. Foreign currency options give their holder the right but not the obligation to purchase (call option) or sell (put option) a specific foreign currency. What this does, is that it safeguards the holder's interest.
If the market rate of the currency is more favorable than the rate he would receive by exercising his option, he will not exercise it, and vice versa. Come what may, he will definitely be receiving (or paying) an amount that is better than what he would have received (or paid) without this strategy.
Interest Rate Options
Just like all the other option derivatives, the interest rate options give the option holder, the right but not the obligation to purchase or sell a specific interest rate contract. What this does, is that both parties are fully aware of their possible payment and receipts. Also, it is a very good cover against interest rate movements, especially if you're holding a naked position (i.e. uncovered position). This option is however used by interest rate speculators, large banks, etc. It is not generally used as a retail vehicle for foreign currency hedging.
Interest Rate Swaps
Interest rate swaps are basically contracts that allow two parties to swap their particular interest rate exposure with another. This is not a risk neutralizing strategy, just a reallocation of interest rate risk exposure. If someone has floating rate payments and he expects the interest rates to rise substantially in the near future, his greatest worry is how much more will he have to pay.
Similarly, for someone with fixed rate receipts, the greatest fear is how much less will he be receiving because of a fall in interest rates. Both the parties (holding opposite views about the future state of interest rates in the market) can then help each others by swapping their contracts with each other and settling the excess receipt or payment. Thus, the first party with the floating obligation will now have a fixed one and the party with the fixed receipts will get a floating receipt.
The best way to hedge foreign currency risk is not to take it on the first place. One can protect oneself from adverse exchange rate or interest rate changes by taking on spot contracts. In spot contracts, contract payments and receipts are settled on the day or on T+1 or T+2 settlement terms. This small duration does not allow for massive exchange rate or interest movements and thus safeguards the person from foreign currency risks. This is also a good (almost cost less) strategy.
Foreign currency hedging can also be undertaken by the way of money market hedges. Money market hedge position can use any of the above vehicles to reduce foreign currency risks. They involve borrowing (or lending) money in one currency and converting the payments (or receipts) back to the original currency, to settle contracts without undertaking any risk. Most rates, even those in the future, are fixed forward rates and all interest earned or paid is also on a fixed rate of interest.
Why Hedge with Foreign Currency?
To Counter Foreign Exchange Risk Exposure
When any trading is undertaken in foreign countries, the trading firms are inevitably exposed to exchange rate movements. This risk of the future exchange rate being unfavorable to any firm, leading to losses, is termed as foreign exchange risk exposure and this can be counteracted by foreign exchange hedging.
To Counter Interest Rate Risk Exposure
When any money is picked up or lent to someone in another foreign country, the interest payments or receipts are subject to the interest rate movements in that country. Substantial movements in interest rates during the term of the contract can lead to abnormal losses to both or either of the parties and this risk is termed as interest rate risk exposure.
To Counter Foreign Investment Valuation Exposure
Taking positions in foreign stocks or stock markets means getting exposed to speculative risk as well as exchange risk. Both these risks, i.e. risk that the stock price may change adversely and the risk that the exchange rate at the exit position may be adverse, together form foreign investment valuation exposure.
For Hedging Open Speculative Positions
Any open positions in any market can be counteracted through the foreign currency hedging vehicles.
Who will Hedge with Foreign Currency?
Anyone exposed to the risks of operating in various different countries or stock markets needs the aids of foreign currency hedging vehicles. Open positions are highly risky and unsafe. Foreign currency hedging makes all these trades a whole lot safer. So, basically, everyone involved in foreign currency positions, will need strategies to neutralize the extra risks that they are picking up.
The problem with foreign currencies is that their exchange rates are very volatile and subject to change. This volatility can translate into heavy losses if there are adverse exchange rate changes between the date of the transaction and the date of the actual receipt or payment. The easiest way that individual investors can hedge against currency risk is through the use of currency-focused ETFs.