Hedging may sound complicated but
all it refers to is methods of trying to reduce your exposure to the
various risks outlined in the other articles in this section. As the
currency market is as volatile and unpredictable as ever, many companies
and individuals are looking to hedge their currency portfolio, corporation
or foreign assets from the risk of fluctuations. A hedge is a term that
is used predominantly in the financial markets in order to describe
a way of protecting or defending yourself and to limit your exposure
to market or currency movements.
There are a range of mechanisms that
allow a company to hedge their currency exposure. One of the most important
and popular of these measures is the use of the forward contract, which
gets rid of any uncertainity as to what happens in the future with regards
to the value of the currency by setting a fixed price now for delivery
of currency at a set date in the future. However, using these forward
contract can sometimes have it's downside and it's important to
consider these as well. For example, one of these downsides that,
due to the fact that it is locked in and can not change, if exchange
rates suddenly increase or decrease in your favour, there is nothing
the buyer can do so it may prevent you from losing money but it also
prevents you from earning money or profits on your currency transfer.
It is also for a fixed amount so it can't change closer to the time.
In addition to this, there may also
be certain complexities that any buyer should consider such as any dividends,
each of which would need to have a separate futures contract. This means
paperwork, and as we all know, paperwork means more time and money is
involved too. Finally, the further into the future you wish to have
maturity of the investment, the harder it is to get a rate that you
consider competitive, because this market is most used for short term
periods like 3 to 6 months, if there are major movements players are
wary of offering anything that seems too competitive on a longer period
of time basis and therefore will pro rata be more expensive to those
that want them.
Potentially the best way of hedging
your currency exchange risk is simply to not take on the risk in first
place. One way of doing this is to use spot contracts. A spot contract
involves contract payments and receipts which are settled on the day
that it is agreed. Because of the little time lapse between the agreement
and the transaction, it prevents any substantial movements or fluctuations
in the currency prices an so protects you from the risk.