Foreign currency dealings are risky, but those who invest or trade internationally must deal in the foreign exchange market, or forex, to exchange currency they have for currency they need. Others enter the forex market as financial speculators. Because currency exchange rates fluctuate multiple times each day as world events influence how people value a foreign currency, forex participants use hedging vehicles to reduce the risk of losses due to unexpected adverse currency exchange movements.
The oldest type of forex hedging vehicle is the forward contract. This is an agreement between two parties to exchange specific quantities of currencies at a specific exchange rate on a specific future date. Forward contracts are made between parties who want to lock in a future exchange rate. Forward contracts can be sold, but there is no regulated exchange for trading them, so each sale is privately negotiated.
Futures are contracts that obligate the holder to buy or sell a specific quantity of currency at a specific price by a specific date. Unlike forward contracts, futures contracts are standardized instruments that are traded on organized exchanges with transactions cleared through institutions known as clearinghouses. Futures contracts are sold on exchanges through an open public auction process. Depending on what a currency investor hopes or fears, he can buy the appropriate futures contract to buy or sell a currency. If the hopes or fears don’t materialize, the investor can cancel the futures contract by buying the opposite contract. For example, a currency buying contract is canceled by an equivalent selling contract.
A currency option is a contract that confers the right but not the obligation to buy or sell a particular currency at a specific price during a specific time period. An option to buy or sell a currency is a form of price insurance. The buyer of a call option, which confers the right to purchase currency at a fixed price, insures against an unexpected surge in a currency’s value. The buyer of a put option, which confers the right to sell at a fixed price, insures against an unexpected fall in a currency’s value. Like other forms of insurance, options sell at a price called a premium. If an option expires unused, the buyer is out the money he paid for the option.
A currency swap is a contract between two parties who agree to exchange a specific amount of currency at a fixed exchange rate on a specific future date. Swaps consist of two legs. In the first leg, Party A exchanges with Party B a quantity of Currency A for the equivalent quantity of Currency B at the current exchange rate. For the second leg, the parties agree that on a specific future date, Party A must return Currency B to Party B and get back Currency A at the same exchange rate as on the day the contract was made. The parties pay each other interest at agreed-upon rates for the duration of the swap contract. Investors use swaps to protect against foreign currency devaluations that reduce the exchange value of foreign investments.
All foreign currency hedging vehicles come at a cost such as carrying charges, interest, option premiums or margin requirements. The rationale for all hedging is to offset foreign exchange risk exposure at a reasonable cost. In an effective hedging strategy, the cost of hedging should be relatively small when compared to the protection hedging provides.
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