What Is Foreign Currency Hedging?

In an increasingly globalized world, where markets are integrated beyond a level of comprehension, foreign currency hedging is used by an increasing number of investors look overseas to diversify their portfolio and protect investment returns.  Industries and markets that most commonly use foreign currency hedging are multinational business’, small firms that trade in imports and exports or essentially anyone that is involved in large scale currency based transactions throughout the world.  In each of these instances, the market or industry is exposed to the risks associated with fluctuating currencies which makes it optimal to use standard hedging strategy by taking two offsetting, contradictory positions, in two parallel markets.  In establishing a foothold in opposing markets, hedging in theory guarantees that the end results offset one other.  This means that excess profit for one of the investments in counteracted by an extra loss in the other, leaving you with your original expectation and protected from the volatility of the markets.  As a result, any wayward exchange rate or interest rate fluctuations do not affect incomes and expenditures.

How it Works?

Trading foreign currency has steadily increased in popularity since the start of the century 2000 as tens of thousands of new traders open new accounts every day. Along with the increasing popularity of currency trading comes a higher demand for the most effective and successful strategies.  Foreign currency hedging promises to drastically reduce risk which in turn empowers currency traders to have the confidence to take positions that would not be possible without the implementation of the counteracting hedged positions.

Types of Currency Hedging

Typically, the two most commonly practiced types of currency hedging strategy are the value adding and value protection strategies.  The first strategy, value adding, uses the process of hedging as a way to multiply the effect or returns.  On the other hand, Protection Strategies use the practice of hedging to protect investments from the risk of currency exposure.  Under both strategies, there also remains the ability to either fully or only partially hedge against currency exposure.  The ability to limit hedging keeps the opportunity to leave some exposure to risk and therefore higher returns still open.  This is important to consider because exchange rates can vary greatly throughout the length of an investment and even on a day-to-day basis.

Risks

Although currency hedging provides the opportunity to enhance investment returns by eliminating uncertainties associated with currency fluctuation, there are also a number of risks that investor must consider before engage in such practices.  Without proper training and knowledge, the ability to eliminate risk can actually be reversed and magnified.  Otherwise, there is also the risk that the measurement for the hedging instrument may not precisely reflect the valuations for the physical securities on which it is based.  Such inaccuracies can stem from timing or pricing variations.  In some cases, although foreign exchange hedging may protect an investor from major fluctuations, it may also limit the ability to experience major gains which can be extremely beneficial if willing to shoulder the risk.