Managing Currency Risk in Forex Trading
Currency risks are risks that arise due to the change in the relative currency valuations. When there is currency depreciation, it can affect the value of your assets and investments. It will also affect your loss or gains when you convert profit from one currency into another. As the currency risks arise due to change in exchange rates, it is also known as exchange rate risk.
Let’s understand this with an example:
Let’s say you are a US-based investor and have purchased a French stock for 200 Euros. Now while you are holding this stock, the exchange rate of the euro falls from 1.5 to 1.3 Euros per US dollar. Now if you sell your stock of 100 Euros, you will have to bear a loss of 13% when you will convert the profit from Euros to US dollars.
Why Do The Currencies Move?
The price at which you can exchange one currency for another is known as the foreign exchange rate. When there is currency fluctuation, the exchange rate will rise or fall. Some factors affect the currency value. These can be trade deficit, slow GDP growth, and increased government debt. If the oil prices rise, the country that exports the oil will have higher currency levels. In addition to this, if a country’s imports are higher than exports, the value of the importer country’s currency drops.
Currency fluctuations are quite common. Studies reveal that currency risks account for 40% of the total risk when investing in foreign stocks. Between 1975 and 2009, due to exchange rate fluctuations, there were 36% currency risks in all short-term investments in US equities. For Japanese equities, it was 30% and for UK ones, it was 28%. So, as an investor, you cannot ignore the risks caused due to currency fluctuations. You need to try and reduce them.
How To Mitigate Currency Risks?
To reduce the impact of exchange rates on your investment portfolio, you must consider hedging. With hedging, you can offset currency fluctuations. This is a risk management strategy wherein you can offset your losses by taking an opposite position in an asset. However, with the reduction of risks, it will also reduce your profits. There are various instruments in hedging such as forwards contracts, options, currency futures, etc.
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When You Should Consider Hedging?
- Generally, you invest in foreign funds for long-term profit. The longer the time of investment, the lesser will be the effect of currency fluctuations on your assets. As a result, your hedging needs will be reduced.
- Consider hedging if your portfolio has high exposure to a particular currency and that currency has been volatile in the past. For example, if you have investments in South African Rand or Turkish Lira.
- Similarly, when you are investing in bonds, you must consider hedging as bonds are more affected by currency changes. Though bonds give you lower returns due to low-interest rates, they can be eaten up by currency rate fluctuations at a rate faster than equity returns. Thus, don’t hesitate to give some extra fees for a hedged variant.
- The cost of hedging must not outweigh the currency downward risk. If it is higher, there is no point in investing in hedging.
- When the economy is stable, there are lesser chances of currency depreciation. In such cases, currencies are less volatile and hedging becomes unnecessary.
What Is The Meaning Of Hedging In Forex?
It refers to the process of mitigating your losses that occur due to fluctuations in the forex market. Several factors influence the forex market and thus hedging strategies become more important for this financial market.
How To Start Hedging In Forex Trading
Generally, advanced and experienced forex traders use hedging strategies as they have in-depth knowledge of the market. However, as a new trader, you can also use hedging strategies. However, before hedging forex, you must understand the forex market and create a suitable plan for trading.
To hedge forex, you must first choose a forex pair to trade. Though it is a personal choice, it is advisable to trade in major currencies as compared to minor. This is because major currencies provide more options for hedging. The liquidity of a currency pair decides its volatility and thus you must decide on hedging based on your currency pair.
Another thing to consider before picking a hedging strategy is to see how much capital and how much time you can invest in trading. Further, before hedging forex, it is advisable to test your strategy in a risk-free environment. For this, you can open a demo account on a trading platform and implement your forex hedging strategy.
Different Forex Hedging Strategies To Mitigate Currency Risks
There are many variables that you can use in a hedging strategy to match your financial goals. However, some approaches are necessary to manage currency risk. These are:
Simple forex hedging strategy
In this, you open an opposite position in the current trade. Let’s understand this with an example. You have a long position in a particular currency pair. Now to hedge it you will need to open a short position in the same currency pair. This is defined a direct hedge.
The direct hedge leads you to Zero net profit. However, when the trend reverses, you will be in your original position on the market. In case, you did not hedge this position, you will have to accept the losses. However, when you are hedging, you will make money through second trade as the market will be in favour of the second position if not the first as the two are opposite.
Hedging Forex with Multiple Currencies
Another forex hedging strategy involves picking two pairs of currency that are positively co-related. For example, GBP/USD or EUR/USD. Now you can take positions on both these currency pairs but in opposite directions. Let’s assume that you have taken a short position on EUR/USD but taking a long position on the other one i.e., GBP/USD.
Now if the Euro falls against the dollar, you have to bear the loss on GBP/USD long position. However, this loss will be compensated by the profit earned in a short position on EUR/USD trade. On the other hand, if the USD dollar falls, your long position profit will offset your short position loss.
Remember that hedging in multiple currencies has its disadvantages. For example, in the above example, you have hedged your exposure to the dollar but there is short exposure to the pound and long exposure to the Euro. In case, the strategy works, risk reduces and you make a profit. Unlike direct hedge that results in net-zero profit, multiple currency hedging can generate more profit at one position than the loss at another position. However, if the strategy fails, you may face losses at both positions.
Hedging Forex with Options
Forex options are one of the popular hedging tools. In this, you get the right to exchange currencies at a pre-set rate on a pre-determined date. However, this is not an obligation for you. This tool reduces your chance of exposure while you only pay for the cost of the option.
Options can be of two types; puts and calls.
With a Put option, you can protect yourself from a fall in currency while the Call option protects you from a rally in the currency. For example, you have traded a long position on AUD/USD at $0.76. Now you expect a sharp decline and thus want to hedge your risk. You can make a put option at $0.74 within a month of expiry.
Now at the time of expiry, if the price falls below $0.74, you will make a loss but your option would be in the money. This will balance your exposure. On the other hand, if the currency pair rises, you will only pay the premium and let your option expire.
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Hedging forex with Exchange-traded funds
You can hedge foreign exchange risk by investing in specialized ETFs. It is a less conventional method of hedging. Currency ETFs are like other ETFs with the difference that instead of stock and bonds, it holds currency cash deposits and derivative instruments that are associated with an underlying currency.
You can either go long or short on these ETFs based on the hedge needed. This way you can protect your cash from currency fluctuations.
Hedging forex with CFDs (contract for difference)
This is quite a popular means of hedging forex. In this, you can compensate any losses against profits for taxes and speculate on decreasing prices. You can use contracts for difference to trade in more than 84 currency pairs. Also, you can trade in 12,000 global markets without taking ownership of physical assets.
Hedging forex with forwards
Forwards are very much similar to options. You can exchange a currency at a previously set price on a fixed date. However, unlike options, here you need to sign a contractual agreement, and thus, it becomes compulsory to fulfill the contract on the set date and time. Future contracts are exchanges traded while forwards are over-the-counter products.
Precautions To Avoid Risk In Forex Trading
Though hedging is an effective tool to mitigate your forex trade risks, it can be disastrous if not executed effectively. No matter how much experience you have and how well-designed a hedge you choose, there are still some possible chances of losses. Always consider factors like commission and swaps carefully.
Avoid indulgence in complex forex hedging strategies if you do not understand the frequent market swings. Learn to time trade to take advantage of the price volatility.
Some forex traders do not believe in hedging as they think currency volatility gives them the experience of trading forex. However, there is no harm in hedging your investments. If you can analyse the market swings, understand the factors that affect them, and are familiar with the correlation matrix of forex, you can maximise your profits with timely forex hedges.
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