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What
Does Hedging Mean in the Forex Market?
Just like in the stock market, forex investors
often use a strategy called hedging to decrease some of the
risk associated with trading. Many people think of
hedging as buying an insurance policy for their currency position,
and it acts in much the same way. By using investment instruments
known as derivatives, forex traders can rest easy knowing that
any losses will be covered by the backup plan.
One type of derivative that many forex traders use to hedge
a position is a futures contract, which is an agreement to
exchange one currency for another at a specified date in the
future at the price on the last closing date. Currency futures
are bought and sold on a market just like any other instrument
such as stocks or currencies, and are a great way to hedge
against changing currency exchange rates. For example, say
you used dollars to take a long position in euros, but you
are a little worried that the price of euros will fall relative
to the dollar. One thing you could do is take out a futures
contract on dollars using euros. As external factors affect
the price of currencies, the price of futures contracts rise
and fall as well, allowing your euros-to-dollars contract to
counteract your long position in euros. If the euro weakens,
the futures contract price rises, and vice-versa, so you have
therefore eliminated the risk from your currency investment.
Another form of hedging in the forex market that is practiced
regularly is done by businesses that deal internationally.
A company that has many customers in Europe may be concerned
that a weakening euro would cost it money in the long run,
as the original price quoted in euros wouldn’t translate into
as many dollars going forward. By taking a long position in
dollars using euros, the company would make just as much money
in the forex market as it lost due to the fall in the euro’s
value. Likewise, if it lost money in the forex market due to
a fall in the value of the dollar, the company would make up
for it in increased profits due to the greater value of the
euros it is bringing in while selling its products. The position
in the forex market has effectively neutralized any threat
the company may have faced due to a weakening euro. This type
of hedging can take several other forms, including futures
contracts and options.
Traditional forex options are derivatives that allow the buyer
to purchase an amount of currency from another trader for a
set price, and make a great hedging tool. Again, these are
instruments that are traded on the open market, and the investor
is under no obligation to follow through with the option. But
sometimes following through is a good way to negate a currency
loss. For example, a person who bought an allotment of yen
with dollars wants to hedge against the price of yen falling
relative to the dollar. What he can do is buy an option to
purchase the same amount of dollars using yen at the price
for which he originally bought the yen. Since options only
cost a small fraction of their denomination, this investor
has just taken out an insurance policy on his long yen position
for a relatively small amount of money. If the price of yen
rises, then he has made a profit on his long position and he
is just out the money he used to buy the option. But, if the
dollar strengthens relative to the yen, he can always wait
and exercise his option, buying additional yen at the now reduced
rate as specified by the currency option. Thus, for a small
option price, he has negated the loss he incurred when the
dollar strengthened and the yen weakened.
By using instruments such as futures contracts and options,
traders can hedge their currency positions for a fraction of
what they paid for their original investment. Also, businesses
operating internationally often hedge in the forex market as
well, taking currency positions to offset any losses caused
by fluctuation in exchange rates. Hedging is a powerful tool
that serves well those who take the time to use it.
# # # # # SolveYourProblem.com : 2007
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