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We must welcome the future, remembering that soon it will be the past, and we must respect the past, knowing that once it was all that was humanly possible.

  • Dara Madee
  • Posted Articles: 13
  • Last Posted: 2017-05-31 07:53:03
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Overcoming Exchange Rate Perils

2016-10-14 10:26:40

Risks from exchange rates are inevitable, but we can hedge against currency perils. How? The general rule is to leave such a risk relative to offshore investments unhedged when a local currency is declining against foreign-investment currency, but overturn this risk when a local currency is escalating against foreign investments. Forex traders can use various instruments or methods to mitigate such dangers.

There are at least four tools for hedging forex risks.

  • Currency ETFs, which are margin-eligible, can be traded either on the short or long side. Used for small amounts of investments, the availability of such funds, having a particular currency as its underlying asset, denotes it can be utilized to hedge forex perils.

  • Another hedging tool is currency forwards, which can be configured to specific amounts and maturities. But individual investors cannot easily access this instrument. For instance, an American investor holds a bond denominated in British pound, which will expire within a year. That holder is worried about the sterling slumping against the US dollar. One option is engaging in a forward contract to sell the pound (tantamount to the bond’s value at maturity), and purchase the greenback at the one-year forward rate. The trader may opt to create a synthetic forward contract employing the money market hedge.

  • Currency futures are traded on an exchange and only requires a small amount of margin. The drawbacks, however, include it is available on pre-set dates and cannot be customized.

  • With currency options, investors or traders hold the right to purchase or sell a currency for a certain amount on or before maturity at the strike price. The premium paid depends on the number of contracts if the option is purchased on a bourse, or the nominal amount of the instrument if bought on the over-the-counter market.

Traders can apply the following methods for hedging exchange rate perils.

  • Creating a well-diversified portfolio. Nothing beats classic moves. Investing in several assets from different classes maximize profits and minimize losses. One can consider holding American Depositary Receipts.

  • Investing in hedged instruments. Hedged ETFs and other overseas assets, especially the bigger ones, can hedge exchange rate perils at a fraction of the cost incurred by a holder.