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Forex hedging colloquial

Forex hedging has emerged as one of the colloquial rescuing strategies for forex investors, individual investors, portfolio managers and corporations for protecting capitals. It is simply the purchase of insurance policy with respect to the currency position. Some real time incidents of rise and fall of forex trading are as follows

  • The Canadian dollar faces a heavy fall against the US dollar since March 2007 due to the drastic decreases in the cost of crude oil.
  • Even the value of Indian Rupees faces a heavy cut after huge capital was pulled way from the market by the foreign investors due to the global financial crunch.
  • In spite of the recent highs attained by the Japanese yen, it falls against other currencies. This was basically caused due to the massive cutting of the rates.

Thus, hedging has emerged as the urgent need for forex traders, with such rampant rises and falls in forex industry.

A derivative, a reliable investment instrument, provides deeper insight to the forex traders regarding the capacity of the backup plans.

The two major kinds of derivatives used in forex hedging are:

  • Futures
  • Options

1. Futures contract is one of the derivatives used by the forex traders for hedging. This follows the exchange agreement in which currencies are exchanged on a particular day, depending solely on the last second value of the closing date just like stocks, the currency futures are thereby sold in any market.

Example: If a forex trader chooses to use dollars for the respective longer position of euros in the current market (say 1.2700). What if the price drops? He then decides to have a short position of 1.2650. He believes that this hot would compensate the loss faced by the longer position. But then, there is no guarantee that the market would witness a rise after the short has been decided by the investor. Thus, to avoid the risk, the investor should go for short(USD/CHF) and long trading with EUR/USD. This creates the currency pairing of EUR/CHF with the 2 different pairs.

2. Internationally dealt businesses employ the other form of forex hedging.

For example, any company with higher number of customers in Europe will definitely be troubled if euro weakens. Obviously, then the earlier conversion rate of euros to dollars wont be applicable. But then it adopts a longer position in rates of dollars, when with respect to euros, it might recoup all the losses. In case, the fall in the rates of dollars is considered, the increased value of euros would cause increase in the profits. Thus, any kind of threat which the company might have faced gets neutralized.

At the same time, it's clever to stick to long for a particular currency pair, offering higher interests. After it, the pair which does not demand interest can be kept for short. Thus, creation of hedge in between the two currencies can be done through options.

Let's imagine, the investor takes the long at 116.00 of USD/JPY. Then, a further long for a put option of strike price is taken at 115.50. For break even, the price needs to go at least 20 pips. At the same time, if the price does not sink lesser than the 115.50, option cost would be lost. Put options would turn quite worthy enough the price goes down than 114. So subtracting the profit on options and loss on position, the investor faces a only loss of 70 pips. Thus, he is hedged, saving himself from stupendous loss.

Though hedging might sound as fool proof, it does not reduce the concept of risk return takeoff. Thus, hedging is not utilized for making money but to lessen the potential losses which might be caused. Thus, it should be adopted with concern.

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