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
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- Last Posted: 2017-05-31 07:53:03
Overcoming Exchange Rate Perils2016-10-14 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.