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All You Need to Know About Forex Currency Hedging –
Forex hedge denotes a transaction done by a forex trader to safeguard an existing or anticipated position from an unwanted move in exchange rates. Forex market is one of the most liquid and volatile financial market in the world.
By making correct use of hedging, a forex trader who is long a currency pair can be protected from downside risk. Similarly a forex trader who is short a currency pair can be protected against upside risk.
There are various methods of forex hedging which a trader can use. The primary ones popularly used in retail forex trade are through
1. Spot contracts and
2. Foreign currency options.
Spot contracts are the ordinary trade transactions made by retail traders.
Spot contracts have a very short delivery period of two days. Hence this method is not very effective in forex hedging. In fact hedge is basically required because of the regular spot contracts.
Foreign currency options are one of the most popular methods of forex hedging. Similar to option trading in other types of securities, foreign currency options also give the purchase the right but not the obligation, to buy or sell the currency pair at a particular exchange rate at some time in future. Here too option strategies like long straddles, long strangles and bull or bear spreads can be adopted to limit the loss potential of a given transaction.
To quote an example of hedging, the forex trader will sell CHF/JPY and at the same time buy GBP/JPY.
The aim here is to make profits from both price movements and interest rate differentials. Presently a long GBP/JPY may earn significant swap interest because of large difference between rates. The forex trader will have to pay interest on the short CHF/JPY. However this interest is significantly less than the interest on the long GBP/JPY position.
Like all forex deals there is considerable amount of risk involved in hedging. Continuing with our example the CHF/JPY currency pair is normally not guaranteed to go in opposite direction to GBP/JPY. Therefore there is always an underlying risk involved in currency hedging.