What is Currency Hedging?
One of the common terms you will come across as you do or study forex exchange is currency hedging. So let’s first start here. What do you know about forex trading? In simpler terms, forex exchange is the process of changing a currency for another.
People trade in the forex market for various reasons. However, one of the uniqueness of this market is that it relies on exchange rates, which fluctuate because of changes in supply and demand in currencies. So now, let’s find out what currency hedging is.
Currency Hedging Explained
As initially stated, forex exchange is done on exchange rates, and these rates keep fluctuating because of the instability in the market. If there is a higher demand for a currency, the prices will rise. These changes can lead to profits or losses.
Now, in a case where the rates negatively change drastically, big companies make huge losses. So, to protect themselves from the negative impacts of exchange rate fluctuations, they enter into a currency hedging financial contract.
So, here is your answer, well explained in the simplest terms. Currency hedging is the act of businesses or individuals protecting themselves against unexpected, expected, or anticipated currency exchange rates changes.
This business tool is common but not limited to large businesses. Small businesses can also apply it in their trading and benefit, although they first need to gain experience in the market. So, how do you hedge a currency on the forex market?
Before committing to forex exchange, know the market. Know where to buy from or whom you sell to on the market. This helps you understand mechanisms that can protect you from changes in the exchange rates. Failure to do this could lead to losses.
There are two ways you can do currency hedging. The first one is fixing. Businesses fix the exchange rates before payments using derivatives. Derivatives are contracts you enter into with a bank to protect yourself from currency rate changes.
Alternatively, businesses opt not to change the currency by buying and selling products in the same currency. Therefore, currency fluctuations do not affect them. This happens if the business trades only in areas where currency fluctuations can be passed on.
Since they are just starting, small business owners should prioritize understanding the negative impacts their businesses can suffer from currency changes and learn more about natural hedging.
Benefits And Disadvantages of Hedging Currency
Our explanation about currency hedging and why businesses use it makes it almost unbelievable that this tool has disadvantages. Well, the benefits could outweigh the disadvantages or vice versa. Take a look.
Here are the reasons to use currency hedging for currency exchange risk management.
Businesses that use hedging programs can see the volatility of the exchange rates, and they can stop the trade or wait for the rates to rise again. This protects them from losses. The companies can also use these rates changes to plan for the next trades, maybe in the following month or year, by increasing or reducing their activities.
Predict the Future Currency Value
Businesses that use hedging get to know the value of the USD in advance. This gives the company the ability to plan with all those changes in mind. They also get a chance to talk to the investors about the impacts of the rate movement.
Profit And Loss Geography
Companies can note the profit and loss geography by looking at the hedged item at the hedged rate after a specific duration. When banks or other hedging companies hedge revenue at a particular rate, they record the revenue and hedge impact in revenue.
It Saves Time For Investors
When you invest in forex, you need to keep checking the system for possibilities of a rise or fall in currency rates. But, unfortunately, some investors do not have the time to keep glued in front of the computer. Hedging locks gains for investors hence saving them from the hustle of checking the system every time.
Protection From Other Negative Market Changes
Hedging aims to reduce losses. This tool also helps businesses navigate economic downturns like inflation, commodity price changes, interest rate changes, and currency changes. These market fluctuations can lead to losses or slow business.
Here are a few drawbacks of hedging currencies.
Hedging is not a free tool, and investing in it can take a big chunk out of your business. Small investors could use their profits to invest in this tool. The gains do not come immediately, and you have to be patient to see the profits.
Deprives the Market Of Flexibility
Investors use hedging tools to protect themselves from the fluctuations of currencies. However, this steals an essential part of the market, flexibility. With flexibility, investors react to market dynamics quickly, bringing a balance between risks and rewards.
Most businesses go for hedging because it reduces risks, but they don’t know that minimizing risks also minimizes the possibility of gaining profits.
Not A Good Idea For Beginners
Hedging mainly benefits the giant investors. Beginners do not have experience, and they might not understand the tool well. Failure to follow the strategies correctly will lead to losses. The new-into-business investors need trading skills to understand this better.
You Can Undo a Hedge
As hard as it might be to believe this, it is true that you can undo a hedge. For example, sometimes the currency rates are unpredictable, and to protect your business from losses, you get a currency hedge. Then, after a while, the market could reverse and go back to normal.
When this happens, there is no longer a need to have currency rates protections so that you can place a stop-loss on the hedging trade. Instead, other investors choose to close it. However, it would be best if you also read about the terms of the hedging company.
If asked, “what is currency hedging,” you can tell what it is and how it’s helpful. Hedging is an indispensable tool for small and large businesses that plan to venture into the forex market. However, you should seek professional guidance before going for this.