Abstract
This paper is on the topic of currency hedging as part of Global Financing and Exchange Rate Mechanisms. The first section of this paper will discuss the use of Currency Hedging in global financial operations. The following section of this paper will describe the importance of currency hedging in management of risks. The final section of this paper will conclude with the basic understandings of currency hedging and its understandings.
Introduction
Currency hedging is done by entering in a financial contract for protecting expected, unexpected or anticipated change in the currency rates. Businesses and financial investors use Currency Hedging for eliminating risks which they encounter while conducting their business internationally. Hedging could be understood as an insurance policy which limits affects of foreign exchange fluctuation risk. Hedging can be done by booking or purchasing different types of contracts which are designed for achieving certain goals. Goals are based on the degree of risk which a customer gets exposed to and seek protection from them to allow individual to get locked in future rates without affecting their liquidity. Hedging can become complicated enterprise, as the hedging mechanisms ranges from basic to extreme level of intricacy. The most prudent step in consideration of hedging strategy is taking note of potential exposure to foreign exchange and evaluating goals needed and actions to be taken for mitigation of risk (Western Union, 2013). To be precise, hedging strategy helps investor to insulate themselves from events of a deal which might threaten them to lose money. To manage currency hedging, it is better to exchange or convert the currency when the exchange rates are favourable and make investment with the currency which is native to the country where the investment is done. Example: Rather paying for stock of a company based out of Japan with US dollars, the investor can convert the dollars to British pounds and use the pounds to make the purchase.
Use of Currency Hedging in Global Financing Operations
Currency Hedging is done for protecting individuals and companies from fluctuating exchange rates in the terms of global financing. The methods of currency hedging include Spot Contracts, Forwards contract, Futures contract and Interest Rate Option.
Spot Contracts
In Spot Contract, investor signs a contact where he/she states that she will trade at foreign currency exchange rate but settlement has to be done within 2 day period. This short settlement timeframe does not permit a lot of time and therefore is not used by itself as it can increase the risk further for investor (Nobile, 2008). Spot Contracts is a form of currency hedging which is used to minimize risks in foreign returns and investment, although Spot Contracts are not considered as the best option making other options more popular as hedging vehicles.
Forwards Contract
Forwards contracts are better option for investors in comparison to spot contracts; this contract locks in the currency rate at a fixed rate for future sale (Nobile, 2008). Exchange rates fluctuate daily and forwards contract minimizes the risk in both instances when rate is high or low on the sale date. This might turn out to be a gamble making it highly important for the buyer to have great understanding of the economic up/down for making well informed decision.
Futures Contract
Futures contracts are similar to forwards, but they are more standardized than their forward counterparts. “Futures contracts have standard contract sizes, time periods, settlement procedures and are traded on regulated exchanges throughout the world” (Nobile, 2008). This offers a currency hedging option with stability to regulations but is an obligation not an option.
Interest Rate Option
Interest Rate Option is a way of hedging currency which allows buyer right to buy/sell an interest rate contract at certain price on or before the contract expiration date (Nobile, 2008). When buyer is unaware of the interest rate at a specific time, this can become cost saving with increase in rate. “Interest rate Options are European-style, cash-settled options on the yield of U.S. Treasury securities” (CBOE). The risk is minimal as there is no obligation to buy at this rate, giving benefit of protection against any rise or fall in rate.
Importance of Currency Hedging in Managing Risk
Risk management is a key issue in life of a forex trader and it is an understandable concept to grasp as a trader, but much difficult to apply. Industry brokers like to discuss the benefits of using leverage and keeping the focus away from drawbacks. It seems quite easy with a demo account but once you start using real money with inclusion of emotions many things change in currency hedging. This makes risk management in currency hedging quite relevant as it helps in:
Tracking Overall Exposure
A reduced lot size is considered good, but it is not helpful in case you end up opening a lot of lots. Understanding the importance of correlation between currency pairs is quite relevant. Example: In case you choose to go short on EURO/USD and Long on USD/CHF, you get exposed to USD twice in the same direction. This equates to state of long in two lots of USD. If USD starts to go down, you will lose money in both options. It is necessary to keep limited overall exposure for reducing risk and keeping the investor in market and liquidated.
Using Correct Lot Sizes
There is no perfect way which will be perfect when you need to choose your lot size, but at the start you should always keep the lot sizes smaller. Every trader has its own level of tolerance for risk. To be conservative is the best way to move ahead. Everyone does not have a huge bank balance to open accounts with, but there is significant risks with using larger lot when you have small account balance. A smaller lot size allows the investor to stay flexible and manage his/her trades on the basis of logic over emotions.
Controlling Losses
Controlling losses is a form of risk management. Everyone should know when to cut losses in case of a trade. It is your choice if you want to choose mental stop or hard stop. Mental stop is a case when you set a limit on how much drawdown or pressure you are willing to take for a trade, whereas hard stop is a case when you stop your losses at a level when you initiate your trade. To figure out when you need to stop should be more logic than emotion, with the main thing or focus should be investor needs to limit his/her risk on a trade which makes sense to them. Once stop loss is in your hand or at the trading platform, you need to stick with it. Investor falls in trap when he/she moves the stop loss farther and farther in future. When an investor does this, they are not cutting their losses rather leading a road to ruin.
Conclusion
Currency Hedging has an important role in Global Financing and Exchange Rate Mechanisms, especially as investors have access to great range of international investments. Hedging helps in lowering risks in portfolio and the choice to hedge or not-to-hedge depends on characteristics of asset being invested in and risk-return objectives of a fund. Investors in international shares might be willing acceptors of currency risk and high-level portfolio volatility in barter of greater return, for assets which are in more defensive asset classes like fixed interest and property; currency hedging remains a long-term strategy for portfolio management.
References
Western Union Business Solutions. (2013). Currency Hedging. Retrieved 16 Jan 2014 from http://business.westernunion.com/resource-center/fx-101/hedging/
Nobile, J., (2008). Types of Foreign Currency Hedging Vehicles in Ezine Articles
Retrieved on Jan 16, 2014 from, http://ezinearticles.com/?Types-of-Foreign-Currency-Hedging-Vehicles&id=33053
Interest Rate Options, CBOE Chicago Board Options Exchange. Retrieved on Jan 16, 2014 from http://www.cboe.com/Products/InterestRateOptionsSpecs.aspx
