If you are operating, a huge MNC or running a business that deals in imports and exports or you are someone who deals with large-scale currency transactions then you would be having knowledge of currency hedging. In the present era of globalization, it is an absolute necessity.
Hedging is basically a strategy to reduce risk. The exchange rates of foreign currency are unpredictable and can change at any time. This instability can lead to heavy losses if there are unfavorable changes in between the transaction date and the actual date of payment. The purpose of currency hedging is to minimize the risk.
Foreign Currency Hedging
Like all the hedging strategies it also involves taking two counterbalancing positions or two opposite positions in different parallel markets. Offsetting positions or counterbalance positions means that the extra loss in one position is compensated by extra profit in the other position.
Foreign Currency Hedging Strategies
There are several ways of hedging the forex risks. They can be divided into internal and external strategies. Some of the internal strategies are:
1. An investor can pay in advance or pay late his forex payments depending on his anticipation of the foreign currency in the future. Depreciation in foreign currency or in other words an appreciation in domestic currency translates into higher payments and lower receipts respectively.
2. Then there is a concept of netting which involves clubbing of the receipts and payments in a currency, by doing this the losses in the receipts are compensated by the gains in a payment.
The external hedging strategies are more popular as they provide a broader scope than the internal. Some external strategies are:
Forward Contracts
A fixed exchange rate for the payments and the receipts is locked by these contracts. Generally, the rate is the forex rate that is determined by the market. The contracts offer stability to the payments and the receipts. Both the receiver and the payer know the amount to be paid or received and the current exchange rate on the transaction date hardly matters. This not only limits the losses but also restrict the extra profits which you would have made otherwise if the rate on the transaction date been more favorable than the predetermined rate.
Currency Swaps
These transactions occur in real time i.e. the exchange takes place immediately without any delay in time. In this the there is an exchange of the principal and payment of a fixed interest contract of one currency is swapped with another currency.
Foreign Currency Options
They derive their value from the fundamental instrument, which they represent. Hence, currency options are based on forex. They give the buyer or seller the right but not the obligation to purchase or sell specific foreign currency.
Spot Contracts
One method by which an individual can guard himself from the unfavorable exchange rates is by taking the spot contracts. Here the payments and receipts for a contract are settled on the day or one or two days after that. As there are fewer chances for massive changes in the exchange rate in this small duration, hence it safeguards the individual from forex risks.
