What is a Forex Hedge?
A Forex hedge is a transaction implemented to protect an existing or anticipated position from an unwanted move in exchange rates. Forex hedges are used by a wide range of market participants. By using a forex hedge properly, an individual who is a long foreign currency pair or expecting to be in the future via a transaction can be protected from risk. Alternatively, a trader or investor who is short a foreign currency pair can protect against upside risk using a forex hedge.
Understanding a Forex Hedge
It is vital to remember that a hedge is not to make money. A forex hedge is meant to protect from losses, not to make a profit. Also, hedges are intended to remove a portion of the risk- not all of it. There are costs to hedging that can outweigh the positives after a while.
Using A Forex Hedge
The primary methods of hedging currency trades are spot contracts, currency futures and foreign currency options. Spot contracts are the standard trades made by retail forex traders. Spot contracts have very short-term delivery dates (two days), they are not the most effective currency hedging vehicle. Regular spot contracts are often why a hedge is needed.
One of the most popular methods of hedging is foreign currency. As with options on other types of securities, foreign currency options give 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.
Example of a Forex Hedge
For example, if a US investment bank was scheduled to repatriate some profits earned in Europe it could hedge some of the expected profits through an option. Because the scheduled transaction would be to sell euro and buy U.S. dollars, the investment bank would buy a put option to sell euro. By buying the put option the company would be locking in an ‘at-worst’ rate for its upcoming transaction, which would be the strike price. As in the Japanese company example, if the currency is above the strike price at expiry then the company would not exercise the option and simply do the transaction in the open market. The cost of the hedge is the cost of the put option.
Not all retail forex brokers allow for hedging within their platforms. Be sure to research the broker you use before beginning to trade.
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