Hedging in Currency Trading
Volatile exchange rates can easily change the price of a previously-established business deal. This may cause a large loss if a company did not use any form of risk reduction. Hedging in currency trading is useful in allowing you to avoid such situations.
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Definition
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Hedging, by definition, is a method to reduce risks associated with the fluctuation of prices. Currency hedging, then, is applied to situations in which one must trade currencies to go forward with a purchase. The idea behind currency hedging is to set take financial positions on both sides of the market to offset any positive or negative fluctuations. In the end, after a fluctuation, your loss in one market is counteracted by your gain in the other market, giving you neutrality in the oscillations of currencies.
Strategies
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There are many currency hedging strategies. Some strategies are speculative, such as paying in advance for foreign goods. Such a strategy would be useful in a situation where you believe your local currency to be depreciating in value compared to the currency of the foreign country from which you plan to purchase goods. Other strategies are cooperative, such as deciding with your foreign business partner on a particular exchange rate at which to make the purchase when the time for purchase arrives. Such a strategy precludes any extreme damage done to a certain party by large fluctuations in exchange rates. There are many other strategies you can employ, some being superior in particular situations.
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Example
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Imagine you plan to purchase a large amount of scooters from Taiwan in six months. You have already established a deal with the producer to pay NT$330,000, which is equivalent to US$10,000. Since you will not make the payment for six months, it is possible the U.S. dollar will depreciate with respect to the new Taiwanese dollar before the deal. You believe the U.S. dollar will indeed fall, so you convert US$10,000 into NT$330,000. Six months from now you may find that the U.S. dollar did fall, but you were not affected as you employed currency hedging.
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References
- Photo Credit currency image by peter Hires Images from Fotolia.com
