Currency hedging can be defined as an act of engaging in financial contracts to provision against losses anticipated from deviations in currency exchange rates. It is a financial strategy used by investors or businesses to reduce the level of risk when performing transactions internationally. Currency hedging resembles an insurance policy put in place to reduce negative outcomes of foreign exchange risks. The concept attempts to minimize the exposure of an investor to unfavorable changes in money market. This is in an attempt to guarantee that a size-able return on investment can be obtained even though currency value falls.
International trade has tremendously grown over time because of inventions of remarkable trading tools such as the internet. This has increased the transparency of trade in international markets. At the same time, international politics and economic factors have elevated uncertainties of foreign exchange rates. This has amplified international markets volatility and the need for currency hedging. Hedging ensures that entities have a growing concern even after contingencies occur due to fluctuations in foreign exchange rates. In hedging, investors seek to exchange currencies when their market value is still favorable. There are various forms of currency hedging that an international investor can use.
Option hedging is the most common and widely used form of hedging. It is rated to be the best form of hedging by numerous investors across the globe. It can be characterized as a trading privilege transferred to the owner (McNew). This means that a trader can purchase or sell his assets in the future market at a specified price. Exchange-traded options were first used in 1937. Over the years, their popularity has tremendously increased. Some traders have been shy to use options out of believes that they are sophisticated and hard to understand. However, when used well, they have numerous advantages. First, they are cost efficient. Options give investors an immense leveraging power. An investor is able to control potential losses without creating a limit to potential gains.
Options are also less risky depending on how they are utilized. Options do not require an intensive financial commitment unlike equities. A large proportion of operating capital is not tied up in hedging operations. They are also impervious to the potential negative effects of gap opening. Options are dependable, and thus safer than stocks. Options offer higher potential returns from a current investment than any other form of hedging. An investor can spend a small amount of funds in provisioning for risk, and obtain a profit which is almost equivalent to the invested amount. This translates into a high percentage of returns to an investor in terms of profits.
When using options, an investor has more strategic investment alternatives. This is because options are very flexible investment tools. Options can be committed to recreate synthetic positions. These positions are representations of investors who have multiple strategies to attain the same investment goals. Options can be extremely beneficial to investors if used wisely. However, they have several disadvantages. First, they cannot offer a full hedge in an investment. Their coverage is partial. At the same time, they can be subjected to basis risk. Options are only drafted for fixed or specified amounts and values. Thus they do not have much liquidity.
The second form of a hedge, is hedging with future contracts. Future contracts in hedging entails the arrangements to purchase or retail assets at a specified time in the future at an agreed upon price. Unlike the forward contracts that are traded over the counter, future contacts are traded during an exchange (Tripathy, 2007, Pp.270). Investors use future contracts to reduce their exposure to risks and also limit the effects of fluctuations in prices to their trade. The goal of future contracts in hedging is to create a perfect offset to risk. Future trading is considered an effective strategy of hedging against volatility of commodities or assets involved. They are several merits of hedging through future contracts.
First, an investor can easily create or declare ownership of assets. Future contracts facilitate simple and reasonable commission fees and plans which are low. They are able to maximize the profit margins and reduce risks when transacting with other equities and funds. The market liquidity when it comes to future contracts is high and readily available. Future contracts are vastly leveraged instruments of finance. They allow an investor to achieve a great deal of gains when only a small amount is invested. Positions while using future contracts can be easily reversed. This means that an investor is capable of opening long and short positions simultaneously.
There are several detriments of using future contracts as a hedging strategy. Just like in option hedging, future contracts offer a partial coverage. Future contracts face basis risks which may set in due to imperfect hedging. For example, the issuer of a bond or a liability can default. Since future contracts have a low commission costs, they may encourage an investor to engage in more trades. This may lead to undesired over-trading. Future contracts are standardized products. This means that they are drafted for fixed amounts and specific terms. The other form of hedging is the use of forward contracts.
Forward contracts are non-standardized treaties between two trading parties. They agree to either buy or sell assets at specified times at agreed upon prices. Forward contract do not require upfront payments like in option contracts (Kwok, 2008, Pp.21). There are several advantages of using forward contracts as hedging strategies. The principal merit is that unlike in other forms of hedging, it offers a full or complete hedge. They can be customized to suit any amount or terms put in place. An investor who uses forward contracts can easily match them with the duration and cash size of the exposures. Forwards provide price protection. They are also easy to understand and use which makes them a preference by many international investors.
Hedging with forward contracts has few detriments. First, the cash flow of an entity is affected. This is because most of the business capital is tied up in the investment until all contracts are settled. Just like in other forms of hedging, forward contracts can be subjected to default or credit risks (Kevin, 2006, Pp.239). Finding a counter party when using forward contracts can be challenging. An investor may also find it rather difficult to cancel contacts before their settlement. When using forward contracts, the physical attributes of a product may vary. For example, the quality of a product may change before successful completion of the contract. Change in quality affects the prices of commodities. However, an investor must oblige to the conditions stated in a contract and pay the agreed upon price.
Hedging risks are unexpected contingencies that may occur and affect profitability of a viable investment during trade on international platforms. There are different categories of hedging risks. They include; commodity risks which arises as a result of potential movements from one region to another. Movement may cause degradation of the quality of products, for example in agriculture products. Credit risk arises when a party under a treaty declines to settle a debt he or she owes. Currency risk is another example, and it is used to deflect losses incurred due to monetary value fluctuations. There form of risk is interest rate risks. These risks occur if the interest rate on loan goes up. They can be hedged using the interest rate swaps. There is also volumetric risk. It occurs when a buyer orders more or less of a product than it was expected.
In conclusion, hedging is an important exercise which helps to control losses that may occur during international trade. International markets are so volatile and losses due to currency fluctuations are always a lingering threat. There are various financial instruments that an investor can use for hedging. Investors should be able to identify hedging risks that face them. This way, they are able to choose the most appropriate form of a hedge. This will ensure that an entity will have an on going concern even after facing setbacks of currency fluctuations in the international markets.