"Higher the return, higher the risk". This is the common mantra about investments. You would be really lucky if you ran into a plan where you would get phenomenal returns with little or no risk involved. Currency trading, in essence works a lot like the stock market, the demand-supply gap deciding the prices. And like share trading on the stock exchange entails a good amount of risk, the same is in the case of Forex trading. Mind you, Forex prices may not just fall, they plummet. And if this happens, it will leave you in a pretty precarious financial position. Frankly, the Forex market is a fickle temptress who might shower her love upon you, but may also dumps you for the dead. So what can you do to minimize the risks associated with foreign exchange trading?
Meaning of Foreign Exchange Hedging
Hedging is understood over the world as a pretty reliable way to minimize risk. Well it is a term that is mostly associated with shares but why can't we apply the same concept in the context of foreign exchange trading? To put it very simply, hedging means dividing the risk. The foresighted among us can spot the shares that are going to do phenomenally well on the stock market in the future, but are not too assured of their success. So, they simultaneously invest in something that is low risk, but assured return to offset the high risk investments, should the foresighted gains not be achieved.
Similarly, risk can also be divided on the foreign exchange market by hedging. If you are able to effectively hedge your funds, then you might even have a zero risk investment proposition even on a volatile field of Forex trading.
Types of Hedging
The risks in the foreign exchange market can be effectively hedged in the following ways.
Forwards: To minimize the risk of the fall in the price of the currency that you are currently holding, a forward agreement is made between the holder of the currency and the prospective buyer. In the agreement, the buyer and the seller agree to trade the currency at a particular rate. This way, the seller is protected from fall in the price of the currency and the buyer is protected from increase in the same.
Futures: Futures trading is quite similar to a forward agreement as even here, the buyer and the seller agree on a price for trading the currency. The only difference being that forward is an agreement that takes place on a predefined future date, while futures transactions are done on a different platform, known as the futures market. Entering a futures market also involves an initial capital outlay.
Options: Options trading is another arrangement made between a buyer and a seller. In options, the two parties make an agreement where, if the price of the currency decreases, the seller can sell it at the fixed price as per the agreement, which shields him from making a loss on the currency. The 'option' is that if the price increases, he can sell it at the increased exchange rate, thus making a profit.
Swaps: A swap is a very low risk form of hedging. In a swap contract, the seller and the buyer exchange equal starting principal amounts at the current spot rate. During the term of the contract, they exchange fixed or floating interest rate payments. At the end of the contract period, both parties re-swap the currencies at the predetermined rate and thus end up with their original currencies.
Foreign Debt: This method is used mostly by exporters to insulate themselves against foreign exchange fluctuations. Suppose the exporter has entered into a contract where he is due to receive a set amount of foreign currency in the future. Now, if the price of that currency with respect to home currency falls, the exporter stands to lose. So what he can do is, he can take a loan in the currency of the foreign country today, to the amount of the currency he is expecting to receive, and convert it into the home currency. Once he receives his payment, he can pay off the loan.
Hedging is a way in which a favorable situation can be created between both the parties in such an agreement.
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