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David has a bachelors degree in architecture, has done research in architecture, arts and design and has worked in the field for several years.

In this lesson, learn what hedging is, examine the different risks involved in the foreign exchange market and explore the strategies for reducing their potential impact. Also, identify some of the methods used in foreign exchange hedging. Updated: 08/19/2021

Risks and Exposure in the Foreign Exchange Market

We often try to reduce our exposure to certain risks. When you drive your car, you put on the seat-belt (or at least, you should). You probably have home insurance, so if something bad happens, you dont lose money.

The foreign exchange market, or Forex, consists of many international transactions of currency exchange that take place between different countries, moving billions of dollars each day. The fluctuations in the exchange rate of the different currencies have become a form of investment, and currencies often make part of the portfolio of commercial banks and many other investors.

However, people and investors in the Forex market are exposed to risks as well. Exposure is the sensitivity to fluctuations in the value of an asset, while risks refer to how much exposure can affect the asset or operation. For example, an importer firm has a big exposure to fluctuations in the currency exchange rate, but if that rate has remained steady for the last few years, the risk is low.

Currencies tend to rise and fall constantly, so they can pose important risks for investors, for importers, exporters and for local industries that use foreign products or services in their processes.

International operators are exposed to sudden movements of the currency exchange rate

The main risks in the foreign exchange are market are transaction risks and translation risk.

Transaction risks are the impact of exchange rate fluctuations on cash flows. Imagine you own U.S.-based company selling to a Japanese firm, and you send products for 1,150 million yen (10 million dollars at the current exchange rate of 115 yen per dollar), payable in 30 days. However, during that month, the yen loses value and the rate changes to 120 yen per dollar. Suddenly, your payment becomes 9.58 million, reducing your profit.

Translation risks involve an asset losing value because of currency exchange variations. If your company also owns real estate in Russia and the ruble devaluates, your property will worth less U.S. dollars, so your asset loses value.

Hedging refers to different strategies that reduce the risks and minimize the impact of eventual adverse movements in the market. It involves using financial instruments to increase protection against unforeseen fluctuations, thus making cash flows more stable and predictable. As a result, companies can estimate income, taxes and revenues more reliably.

However, hedging is not a way of making more money. It is rather a series of methods for minimizing risks. Hedging reduces not only your potential loses, but it also reduces potential sudden earnings.

For investors, hedging is like buying insurance on their assets or portfolios. Foreign exchange hedging is common among investors and companies involved in international operations. It allows them to manage their exposure to currency exchange movements and minimize the impact of adverse fluctuations.

Some companies might choose to hedge 100% of the portfolio, while others might not hedge at all. Most of them, however, are likely to hedge a percentage, so they partially protect themselves but also accept some risks and leave the door open to additional earnings. It depends on their particular tolerance to risk.

Main Methods for Hedging Foreign Exchange Risk

Different assets and types of investments have different methods for hedging, so there is no specific set of tools for hedging. In foreign exchange, however, hedging methods mostly consist of specific contracts or agreements meant to exchange currency at a fixed rate.

Lets examine some of the most important and common options.

Forward Contracts

Forwards contracts or forwards are agreements between two parties to buy or a sell a specific amount of currency at a predefined exchange rate. If the foreign currency youll be exchanging into domestic currency loses value, you will still receive the exchange rate specified in the contract, so you wont lose any money. However, if the foreign currency appreciates, you will still receive the same exchange rate, so there are no additional earning.

Forward contracts allow companies to buy or sell currency at some point in the future, using the current exchange rate

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