Forex Hedging

Forex Hedging was one of the main drivers behind the explosive growth of the FX markets that gathered momentum the early 1980s. Foreign Exchange controls which had restricted the movement of capital were abandoned in the UK in 1979. As a result companies could mitigate their FX exposure and were able to plan for the future and price their products accordingly.

For example if you were an exporter of fine china, with customers in the USA and sales in US Dollars but your overheads were in Sterling. Then you might wish to exchange your income in Dollars for Sterling on a regular basis, to avoid unnecessary currency exposure.

Equally a UK company that imported machine tools from Japan may have wished to sell Sterling to buy Yen periodically, in order to fix its costs. With free access to the currency markets companies were able to expand overseas. Furthermore they could raise finance internationally, from wherever capital was cheapest. For example borrowing money in US dollars and then converting and using those funds to build a factory or warehouse in France.

Free movement of capital and access to Foreign Exchange (or FX if you prefer) were the precursors to globalisation. Which for better or worse has and continues to shape the modern world.

Increasing use

As access to Foreign Exchange and overseas trade became more commonplace companies became more sophisticated in their requirements. Management could decide to take a view on their overseas sales and costs at the start of the year. And at the same time look at what they felt was likely to happen to relevant FX rates, over say the next 12 months. If they believed that these rates would move against them. Then they could “hedge” their exposure by selling or buying the appropriate currencies. They could also adjust their Forex Hedging throughout the year if their forecasts proved to be incorrect.

Forex Hedging for traders

Just as the speculative Forex markets developed from the corporate market so the practise of Forex Hedging moved from the corporate world into the world of Margin FX.

For example if you are investor with overseas share holdings, you may wish to protect their value through a Forex Hedge. Lets imagine that you anticipate the value of those investments will rise near term, whilst the currency they are denominated in is expected to fall against your base or domestic currency. If the price of these investments rose by 5% over the next month but at the same time the currency they are denominated in declined by the same amount, against your base currency. You would realise little or no return. However if you used Forex Hedging and sold the investments underlying currency (in the same size as the underlying investments value) subsequently buying it back after the drop, then you would benefit from the nominal rise in the underlying investments value. What’s more in this instance you would have realised a profit without having to sell the original investment.

Of course if your intuition about the currency is wrong and in particular if it appreciates versus your base currency, rather than depreciating, then the use of Forex Hedging could start to work against you. At that point you may choose to take off the Hedge by buying the short (sale) position back. Given the 24 hour a day 5 days a week nature of the FX markets closing your Forex Hedging positions should be very straightforward. What’s more using non deliverable margin trading to facilitate your Forex Hedging means you can benefit from the use of leverage and low deposits. Though always bear in mind that leverage works both ways. That is it amplifies profits and losses in equal measure and therefore that you could lose more money than you have placed on account.

Diversifying Risk

It also possible to use Forex Hedging to protect or diversify a portfolio of FX positions.
More than almost any other group of financial assets FX pairs and crosses share correlations. These correlations come about as a result of their underlying relationship with their peers and the US dollar. To which all currency prices are ultimately re-based to, or calculated from. That said these correlations are not uniform and they can be either positive or negative, strong or weak in nature and they can and do vary in strength and direction over time.

A spread of FX positions in different currency pairs may on the face of it appear to offer diversified exposure and to be spreading an investor’s risk. However if the positions in question are in the same direction and they all share some degree of positive correlation (that is a relationship where a change in the price of one will result in a price change in the same direction in the other positions), then they are offering anything but this.

Instead of diversifying exposure they are likely to be concentrating risk. However the investor can use Forex Hedging to open a position in the opposite direction, in a negatively correlated instrument, which should move in the opposite direction to the other positions in the portfolio and which therefore offers diversification and acts as a Forex Hedge.

Sterilise Positions

Traders can also sterilise some or all of their exposure via Forex Hedging.They can do this by taking an equal and opposite position to an open position on their account. So for example if they are long GBP USD and wish to remain in that position but are unable to monitor the price (if they are flying for example) then they may choose to open a short GBP USD position, in the same size. The P&L of this position will move in the opposite direction to the long position and will act as a hedge to the downside. Though it will also negate any additional upside in the original position. One of the benefits of this type of Forex Hedging is that it reduces the Trader’s margin requirements, in some cases to zero, for the sterilised positions.

A powerful and useful tool

The ability for companies to Hedge Forex exposure has been one of the main drivers of global growth. In turn this has helped to break down trade barriers and bring millions of people from the emerging economies into the global marketplace. This has therefore been of one of the biggest agents for change over the last 50 years.

Forex Hedging forms an important part of a trader’s toolbox, particular when they are looking to diversify their exposure or protect the value of investments held elsewhere, in a currency other than their domestic or base currency. Indeed sophisticated investors may even use Forex Hedging for asset allocation purposes. For example if they wish to quickly gain broad brush US Dollar exposure after some key data is released.

Understanding when to use Forex Hedging comes with experience of the markets. But even those new to trading can experiment with the practice by simply opening forex trading account and downloading the Blackwell Trader MT4 platform for their desktop PC or mobile device (iOS or Android).

When used in conjunction with a demo trading account the platform offers a highly realistic simulation of the live markets, within which traders can perfect their Forex Hedging strategy without risking any real money. So why not start today ?