Foreign Exchange Hedging Policy
Foreign exchange is essential for global commerce. Foreign exchange relates to the process of converting domestic banknotes into international currencies. Foreign exchange does introduce distinct risks, related to adverse currency movements that reduce your purchasing power. Foreign exchange hedging policies are designed to manage these risks, and are most effective when you can identify the global economic trends that influence currency values.
Other People Are Reading
-
Identification
-
Foreign exchange rates parallel the economic and political strength of a particular nation. Stronger exchange rates are associated with economic growth, as investors covet a nation’s currency to buy its appreciating stocks, bonds and real estate. Conversely, exchange rates generally fall amidst recession and unfavorable political legislation. For example, foreigners may refuse to do business in countries that levy heavy import duties and quotas.
Foreign exchange risks carry an inverse relationship toward buyers and sellers. Consumers lose purchasing power when domestic exchange rates fall. Alternatively, exporters are less competitive as domestic exchange rates increase, because foreign buyers must then contend with higher prices. Beyond buying and selling goods, individuals who hold currency reserves suffer losses when those currencies decline in value.
Benefits
-
Foreign exchange hedging policy is designed to stabilize cash flow, so that private individuals and institutions can coordinate effective budgets. Without hedging, extreme swings in currency valuations could lead to severe financial losses, or even bankruptcy. Foreign exchange hedge products, such as currency options, may even be traded in their own right for profit.
-
Considerations
-
Foreign exchange hedging techniques may be categorized into currency swaps and derivatives. Currency swaps are situations where trading partners agree to exchange payments denominated in different currencies throughout the duration of the agreement. Rather than simultaneously exchanging multiple payments, swaps net at maturity, and the winning party earns the difference in value between the two currencies.
In addition to swaps, currency derivatives, such as options, futures and forwards, are contracts between trading partners that effectively lock in exchange rates over set periods. Options and futures trade throughout the day on organized exchanges, such as the Chicago Mercantile Exchange. Meanwhile, forwards are customized agreements between two parties to negotiate exchange rates at predetermined dates.
Currency swaps and derivatives may be combined with interest rate swaps, where trading parties exchange payments at fixed and adjustable interest rates. Interest rate swaps are ideal for borrowers and lenders. Without these agreements, higher interest rates, alongside weaker exchange rates for domestic currency, would significantly increase the costs of paying down overseas debt.
Strategy
-
Investors can diversify their profit sources to hedge against currency risks. Domestic corporations often establish multinational operations, so that one nation and currency cannot dominate earnings. Smaller investors can purchase shares within multinational corporations or global mutual funds to achieve diversification and hedge currency risks. Notable multinational firms include Coca-Cola and Nike.
Warning
-
Foreign exchange hedging policy limits your profit potential, if exchange rates and economic conditions were to actually move in your favor. Further, diversifying into foreign territories may even increase risks. In 2006, Wal-Mart sold off its German stores at a $1 billion loss.
-
References
Resources
- Photo Credit dollar bill image by jimcox40 from Fotolia.com
