How to Mitigate Foreign Exchange Rate Risk

Buy strength, sell weakness.

Mitigating foreign exchange risk means to reduce the effect of currency translation or currency effect on a financial instrument. Thus, the true financial return can be measured on the basis of capital gains and dividends. There are many ways to mitigate or hedge financial risk in currencies.

Instructions

1. Open a futures account at a brokerage firm that trades foreign currencies. Opening an account includes opening a margin account so that the trader can use leverage. Understand that you are personally responsible for any failure to meet initial margin or maintenance margin. Choose a broker with a trading platform you understand and can manipulate easily. Make certain you know how to place orders and limit losses online.

2. Consider the risk you wish to mitigate. If it is fluctuating value, calculate a minimum value (as you would with an insurance policy) and the currency at which the asset is valued. Short the currency in the amount of the minimum value. Then, subtract the minimum value from the current value and short that amount. This latter amount should be checked periodically and the short recalibrated as necessary.

3. Buy put or call options, depending on whether you believe the security to be hedged is rising or declining in value. If you believe the currency underlying the security is rising, then purchase a call. Use puts or don't hedge at all if you believe the currency is declining. Options limit your market risk, but you may pay a stiff price for the protection they provide. Understand that most options have multiple expiration dates within six months of the current date.

4. Mitigate risk of a company by demanding payment in the home currency. Lower risk for a foreign company reporting in U.S. dollars by making the payment terms in dollars. Know that this is common practice in the international oil business, for example.

5. Buy stock of foreign companies denominated in U.S. dollars. Diversify your stock portfolio by buying U.S.-based international companies rather than buying the stocks of competing local foreign businesses. U.S. companies must report earnings in dollars and do their own hedging internally.

Tips & Warnings

• Always practice-trade before employing real money.

• Understand the technical aspects of futures trading before undertaking real trades.

References

• Federal Reserve Publication on Trading

Resources

• Understanding Foreign Exchange Rates