Hedging Currency Risk - How & Why
A Forex hedge is used by investors as insurance against adverse exchange rate movements. Discover more about currency hedging in our thorough guide.
Building a Hedge Around your Savings
As currencies can sometimes have large price movements over a short period, the performance of hedged versus non-hedged portfolios can show substantial differences in global results over any period. Therefore, acquiring investment positions in foreign currencies can truly impact the overall performance of your portfolio if not hedged, as it would have to face higher volatility.
What does currency hedging truly means? Which Forex hedging strategy is the most profitable. And, what impact does Forex hedging has on the investor? This article is here to explain the benefits of hedging as protection of investment against currency risk.
What is Currency Hedging?
Currency hedging is a term that describes the process in which a forex pair is used to protect an investor against the possibility that an adverse exchange rate could result in the investor’s capital losing value through some other asset. It acts as an insurance policy that reduces financial risk.
For example, let’s say you want to buy Yen because you intend to buy Japanese stocks on the Japanese stock exchange.
To buy your Japanese Yen, you will use your U.S. Dollars. You expect to hold the stocks for a period of one year before selling them and converting the Yen back into US Dollars. If you do this without protecting yourself, you will end up facing risk, as changes in the currency pair value can strongly impact your P&L.
If you were to sell 2 million dollars at a USD/JPY exchange rate of 109.80, you would receive 219,600,000 Yen. You would then use the Yen to buy Japanese stocks. Without hedging this transaction, you run the risk of the Yen appreciating against the Dollar over the year that you hold the stocks.
When you sell the stock and exchange the Yen into Dollars, you will have received fewer Dollars than you started with.
Let’s assume the USD/JPY was 110.00 when you repurchased your Dollars. You would have received only 1,996,364 Dollars, approximately 3,636 short. Of course, if the Yen had depreciated over that period, you would have made a profit. However, by not hedging this transaction, you stand to lose some of your capital.
What Forex Strategy Could You Use to Reduce this Risk?
With the above example, there are several ways you could insure yourself against currency risk. Suitable methods include Forex swaps, Forex forwards, futures or options, for instance.
As the objective of using hedging is to reduce currency risk, instead of earning extra money on the transaction, you need to invest in an additional financial product that is negatively correlated with the transaction currency pair.
Remember that a correlation in financial markets represents the extent to which two assets fluctuate together. A positive correlation means that these assets rise or fall together at the same time, while a negative correlation indicates that both assets tend to evolve in opposition directions – when one increases, the other decreases in value and vice-versa.
Of course, the degree of correlation varies, which can strengthen the relationship between two assets. It all depends on the correlation coefficient, which measures the degree to which a change in one asset’s price can impact the price of another asset.
By using FX hedging, you can ensure that all losses and gains offset each other, which therefore minimizes currency risk. It is logical that the higher the risk, the higher the opportunity, but also, the greater the loss.
As the hedge is reduced, the greater the opportunity for increased earnings or losses. Conversely, as the risk is reduced, the potential for increased earnings and losses are also reduced.
In our previous example, you bought the Yen in order to buy Japanese stocks. Therefore, you could have reduced your currency risk by using a Forex forward instrument and sold the Yen forward to coincide with when you decided to sell your stock. That is the simplest form of Forex hedges available to the investor and hence, reduces their currency risk to a known quantity.
Tips when Investing in International Markets
When investing internationally, remember that the performance of the underlying asset you are investing in is not the only aspect to consider. Of course, you are mainly investing in an asset hoping that its price will rise, but you need to consider that the currency used for this purchase might also play a role in this investment’s performance.
While the ideal scenario would be to be right on both – the asset price going up and a strengthening of the currency used against your currency – you should be ready for the worst-case scenario where both, the asset and the currency used, lose value. And here, currency hedging can help.
forex hedging can also be used for diversification benefits. Remember that diversification can also be used to reduce the overall financial risk on a portfolio.
When you decide to diversify your investments, you need to use uncorrelated assets (or assets with negative correlation) to be sure that not all of your positions are evolving in the same direction at the same time.
Investing in international markets can be a good way to diversify your portfolio by investing in different geographical markets and different currencies. Of course, currencies from foreign investments can be risky, which means that you should consider ways to protect your investments, like forex hedging.
With hedging, you will be able to reduce risks by offsetting a possible loss in an international investment through another related investment that will increase in price while the original investment possibly loses value.
While hedging involves opening a position on a related investment to reduce a certain risk, like currency risk, diversification involves choosing different unrelated investments to mitigate your overall risk.