Hedging in the forex (foreign exchange) market involves taking positions to protect against adverse currency movements. By hedging, traders and businesses can limit their exposure to currency fluctuations and reduce the unpredictability of their portfolios.
Here are several examples of hedging in forex:
- Simple Forex Hedge:
- A U.S. company expects to receive EUR 1 million in three months for a product it sold in Europe. The company is concerned about the Euro weakening against the U.S. dollar in the next three months. To hedge, the company can sell EUR 1 million forward, locking in today’s exchange rate. If the Euro falls in value, the forward contract gain offsets the currency conversion loss.
- Multiple Currency Pairs Hedge:
- A trader anticipates the Euro will strengthen against the U.S. dollar but is uncertain about its movement against the British pound. The trader could go long on EUR/USD (buying Euro and selling U.S. dollars) and simultaneously go short on EUR/GBP (selling Euro and buying British pounds). This hedges against the risk of the Euro weakening only against the pound.
- Forex Options Hedge:
- A U.S. tourist plans to travel to Europe in six months and believes the Euro might get more robust against the U.S. dollar by then. To hedge against this potential cost increase, tourists could buy a forex option that gives them the right (but not the obligation) to exchange U.S. dollars for Euros at a set rate. If the Euro does strengthen, the tourist can exercise the option and save on the exchange rate.
- Money Market Hedge:
- An Australian company owes a U.S. supplier USD 1 million, payable in a year. They expect the U.S. dollar to appreciate against the Australian dollar. The company could borrow an amount in USD (such that its present value equals the USD 1 million) and immediately convert this to AUD at the current spot rate. The money is then invested in an Australian interest-bearing account. At the end of the period, the AUD amount (plus interest) should cover the AUD equivalent of the USD 1 million due, and the USD loan can be repaid using the original USD 1 million receivable.
- Operational Hedge:
- A company could establish operations in another country to offset its currency exposure. For example, a U.S. company selling products in Japan, earning in JPY, could also source materials or set up manufacturing in Japan. This way, even if the JPY weakens against the USD, the company’s increased costs in USD terms (from the revenue side) could be offset by reduced costs in JPY terms (from the cost side).
- Currency Correlation Hedge:
- If a trader believes that the Canadian dollar (CAD) will strengthen against the U.S. dollar but is unsure of the magnitude, they might take a position in another currency that’s correlated with the CAD. For instance, since oil prices often influence both the CAD and the Norwegian Krone (NOK), a trader might buy both CAD/USD and NOK/USD. If CAD doesn’t move as expected, the NOK position might still profit if oil prices rise.
Simple Forex Hedge Example
Hedging Options and Forex
A forex option hedge can be a useful strategy to mitigate potential losses due to unfavorable price movements. Let’s go through an example that illustrates how a trader might use a forex option in conjunction with a Contract for Difference (CFD) position on the EUR/USD pair.
Scenario:
- Buying the EUR/USD CFD: Suppose a trader believes that the Euro will strengthen against the US Dollar in the next month. He decides to buy a CFD on EUR/USD at the current rate of 1.1000, hoping to benefit from a rise in the exchange rate.
- Concerns about potential decline: While the trader is optimistic about the Euro’s prospects, he is also concerned that there might be a chance the Euro could weaken instead, leading to a loss. To protect against this risk, he considers buying a put option on the EUR/USD.
- Buying the EUR/USD Put Option: He buys a one-month EUR/USD put option with a strike price of 1.0900. This gives him the right, but not the obligation, to sell the EUR/USD at this price within the next month. For this option, he pays a premium, let’s say 50 pips, or $500 for one standard lot (100,000 units).
Possible Outcomes:
- EUR/USD Rises: If the EUR/USD rises to 1.1200 within the month, the trader makes a profit from his CFD position, earning 200 pips, or $2,000 for one standard lot. However, the put option will expire worthless since it’s out of the money. Considering the option premium paid, the net profit would be: $2,000 – $500 = $1,500.
- EUR/USD Declines Below the Strike Price: If the EUR/USD drops to 1.0800, the trader will lose 200 pips, or $2,000 on the CFD. However, his put option will be in the money, allowing him to sell the EUR/USD at 1.0900, gaining 100 pips or $1,000. Taking into account the option premium, the net loss would be: $2,000 – $1,000 – $500 = $1,500.
- EUR/USD Declines but Remains Above the Strike Price: If the EUR/USD drops to 1.0950, the trader will lose 50 pips or $500 from the CFD. The option will expire worthless since the rate never reached the strike price. Including the premium, the total loss is $1,000.
In each of these scenarios, the forex option acts as a hedge, providing protection against adverse price moves. However, the cost of this protection is the option premium, which can impact the overall profitability of the strategy.
Hedging in trading
In trading, hedging is the practice of making an investment to offset potential losses or gains that may be incurred by another investment. Traders hedge various types of assets based on the market they are involved in, the risks they perceive, and their investment strategy. Some of the most commonly hedged assets include:
- Currencies:
- Forex traders, multinational corporations, and investors who have international exposure might hedge against potential losses due to currency fluctuations.
- Instruments: Forward contracts, futures contracts, options, and swaps.
- Example: If a U.S. company expects to receive Euros in three months for a contract, but they are concerned that the Euro might weaken against the dollar, they can lock in a future exchange rate with a forward contract.
- Equities (stocks):
- Equity investors hedge against potential price drops in the stocks they hold.
- Instruments: Options (especially put options), equity index futures, inverse ETFs.
- Example: An investor holds a large position in Company A’s stock and buys a put option on the same stock. If the stock price falls, the put option will increase in value, offsetting some or all of the losses.
- Interest Rates:
- Institutions and traders who are sensitive to interest rate changes, such as banks, might hedge against fluctuations in interest rates.
- Instruments: Interest rate futures, options on interest rate futures, swaps.
- Example: A bank might use interest rate swaps to transform its fixed-rate liabilities into floating-rate liabilities if it expects interest rates to fall.
- Commodities:
- Producers and consumers of commodities like oil, gold, or agricultural products may hedge to protect against price changes.
- Instruments: Futures contracts, options on futures.
- Example: An airline expecting to buy jet fuel in the future might enter into futures contracts to lock in today’s prices and protect against potential future price hikes.
- Credit Risk:
- Institutions looking to hedge against the risk of credit events like default.
- Instruments: Credit default swaps (CDS).
- Example: If a bank is concerned about a corporate bond it holds and the potential for the company to default, it can buy a CDS as insurance against that default.
- Equity Market Volatility:
- Investors concerned about the overall volatility of the stock market.
- Instruments: VIX futures and options (VIX is the volatility index).
- Example: If an investor believes that the market might become more volatile (but is unsure of direction), they might buy VIX futures.
Trader at Leanta Capital
Igor has been a trader since 2007. Currently, Igor works for several prop trading companies.
He is an expert in financial niche, long-term trading, and weekly technical levels.
The primary field of Igor's research is the application of machine learning in algorithmic trading.
Education: Computer Engineering and Ph.D. in machine learning.
Igor regularly publishes trading-related videos on the Fxigor Youtube channel.
To contact Igor write on:
igor@forex.in.rs
He is an expert in financial niche, long-term trading, and weekly technical levels.
The primary field of Igor's research is the application of machine learning in algorithmic trading.
Education: Computer Engineering and Ph.D. in machine learning.
Igor regularly publishes trading-related videos on the Fxigor Youtube channel.
To contact Igor write on:
igor@forex.in.rs
