Hedging is a strategy which an investor takes to protect their profits or limit their losses. The investor could be individuals or business entities. Foreign Exchange Market because of its volatility specially when trading in currencies, calls for following procedures laid down to protect their profit margins.
Every time a currency is exchanged from domestic to foreign there is a foreign exchange exposure risk associated with it. It is basically an effect of unexpected changes in the exchange rate on the value of a firm.
With currency market being the largest and working round the clock, the fluctuation is extremely high. This leads to risk of changes in future cash flows. The transaction rate at which the contract is executed is different from the realization rate when the funds are received.
Foreign exchange exposure calls for management of this risk which could ultimately affect the bottom line of the corporate. Exchange rate risk management should be part of every corporate forex policy. The risk tools work well to hedge the risk associated with foreign exchange exposure. This basically entails exposures like transaction, translation and operation to avoid potentially adverse currency effects on profitability and market valuation.
Foreign Exchange Hedging Strategies are used for risk management. These are either over the counter (OTC) or exchange-traded products. Most common hedging instruments like forward, options or futures contracts are widely used by traders and corporate alike.
OTC currency forwards involves buying a currency contract at a price set today, for a future delivery. There are two types of forward contracts – outright forward and non-deliverable forwards (NDF). Outright forward contract involve physical delivery of currencies whereas NDF contracts are settled on a net cash basis. Since the price is set on the day of contract, the transaction is said to be fully hedged. But this has the risk of exchange rate moving in the opposite direction which accounts for an opportunity loss.
Option contract is an alternate strategy which is basically a contract wherein entities have agreed to exchange a set amount of currency at a given rate sometime in the future, the entity on one side of the agreement is not obliged to do so, i.e. it has the option to see the contract through or effectively cancel it. This gives that party the option to see through the contract and take the currency at the stipulated rate, or enter the spot market for that currency if its exchange rate is more favorable to that outlined in the option agreement.
These foreign exchange hedging strategies is basically hedging of currency risk. The above products offset or limit the exchange rate fluctuation thereby protecting the company’s investment from the risk of loss. If there is an exposure in multiple currencies, then hedging becomes even more vital.
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