13 September 2023
Hedging Strategies in Forex: An Advanced Guide
Forex trading can be unpredictable. Even the best forex strategies can fail and leave investors scratching their heads. To protect against the exposure, some investors open a second position with an inverse currency correlation with the primary asset to protect against a possible loss.
The essence of hedging is to protect an investor from uncertain and adverse outcomes in forex markets. But how does hedging play out, and how can you benefit from it?
The Necessity of Hedging in Forex Trading
In forex trading, hedging is a form of risk management that seeks to reduce risk exposure to a financial instrument. It lets the trader take cover against potential future adverse price changes. Below are some more details.
The Concept of Hedging
When hedging in forex, you essentially take a position opposite to the leading trade in a currency pair. Traders can hold two or more positions simultaneously. Should a trade go contrary to the initial position, the other position offsets its losses.
Perhaps you might ask: Why should you hedge a currency position? After all, there is a circumscribed loss from one of the two held positions. From an investment perspective, the primary aim of hedging is to minimize exposure rather than turn a profit.
For example, assume Company A has a major order for crude oil to be delivered in six months by Company B. However, due to forex market uncertainty and volatility, it expects the price of crude oil to rise by the time the order is delivered. To mitigate against the risk, Company A will buy futures contracts that lock prices at a particular level.
In the above case, the futures contracts give company A the legal right to purchase crude oil from company B at a predetermined price at a specified future date. This is necessary if the company cannot conduct spot contracts and settle transactions at the current or known rate.
Overall, the following are the apparent reasons for hedging in forex markets:
To minimize currency risk
To avoid currency risk involving foreign assets
To protect company margins
To smooth rates for future transactions and budgeting
Hedging vs. Speculating
Hedging and speculation are commonly used terms in forex, but they mean different things. Remember that hedging focuses on offsetting an adverse outcome by taking a contrary position to the primary trade. In the strictest sense, hedging is a risk-neutralizing strategy in forex markets.
Speculating means holding a position in anticipation of returning a profit from a price change of a financial instrument. For example, if you anticipate the euro’s value increasing against the dollar, you buy and sell the former. Similarly, an investor may view an asset as underpriced and buy it in anticipation of gaining from its value increase.
A major distinction is that speculators target a profit while hedgers want to protect the downsides. As such, speculators are vulnerable should the outcome of a prediction go contrary to the position held.
Types of Hedging Strategies in Forex
In forex, simple forex hedging and multiple currencies hedging are predominantly used.
Simple (Direct) Forex Hedging
This is the simplest form of hedging strategies in forex markets. The hedging technique involves taking a short and long position simultaneously on the same currency. For example, if you opened a long position on EURUSD, you could consider a short on the currency pair.
Typically, the profit net of the position would be zero. So, why hedge in such a case?
Often, direct hedging is practised by traders who hold long-term trades and want trades to run rather than liquidate them on changed market conditions. For example, if a long trader expects some impact news that may cause the price to fall, they may create a short position for it.
The trader will then profit from the hedge (short position) if the trade goes against their initial prediction while protecting the long position. They may then keep the original position while waiting to see how the trade evolves.
In most cases, however, most traders would use direct hedging to protect gains already made on a trade. This is done by opening short trades against an already profitable trade. Even if the trade contradicts the trader, they can still withdraw from the initial favourable price swing.
Multiple Currencies Hedging
You can hedge against currency risk using several assets in multiple currency hedging techniques. Under this approach, a trader buys one currency pair to hedge a different one. For example, buying GBPUSD to hedge against EURUSD.
The currency pairs selected for hedging are positively correlated. In the example of GBPUSD and EURUSD, the two pairs are closely correlated due to the close relationship of the British pound and the euro. However, the hedger will take positions in opposite directions, like buying GBPUSD and short EURUSD.
Let's take a hypothetical scenario where you decide to hedge a USD position by shorting EURUSD against a GBPUSD long. If the dollar increases in value, pushing GBPUSD lower, you would offset the loss with the gains on the EURUSD (hedge), assuming the euro and pound move similarly.
The advantage of multiple currencies hedging is that you generate more profit from the position that works compared to the loss made on the contrary trade. In some rare cases, you might turn a profit on both.
Nonetheless, you need a clear, thought-out strategy for the hedging technique. Even the most correlated assets may not move in the same direction. Thus, there is the possibility of multiple losses on the various positions held.
Advanced Hedging Tools and Techniques
Hedging is used beyond forex trading by institutions exposed to foreign exchange markets and transactions. These organizations use various advanced tools and techniques to protect against their exposure. Examples of these are options and interest rate differentials.
Using Forex Options for Hedging
Many cross-border organizations are concerned about changes in exchange rates and would want to smooth the volatility. However, even with the best-managed forex operations, providing accurate forecasts is always challenging due to inevitable and sudden market occurrences. Options trading or contracts are flexible instruments to manage the complex web of forex exposures.
An option is a contract between two parties to settle a future transaction at a predetermined strike price. Options are exercised before or on the expiration date. The option holder or buyer pays a premium to protect the financial instrument from an adverse outcome.
When hedging, investors can use two types of option contracts – call options and put options.
Call options: These are options that give the holder the right to buy an underlying asset at a specified price before or at the expiry of the contract. Investors who hedge using call options expect the underlying asset's price to increase. In doing so, investors anticipate exercising the call option by purchasing the asset at a price below the market.
Put options: Put options give the holder the right but not the obligation to sell an underlying asset at the strike price before or on the expiry of the contract. Put options to protect the investor if the underlying asset falls in value. As a result, investors can sell the asset at a higher price and be protected from downside risks.
When hedging using options, investors must evaluate how much they pay as a premium. An ideal hedging option should leave the investor at a zero or positive net balance after taking care of the premium payment.
With options, investors can hedge multiple instruments. These can be stocks, forex, commodities, and indices. In the hypothetical example below, we detail how investors can hedge a stock exposure using share options:
Assume investor A owns 10,000 shares currently trading at $2 in Company X. The shareholding gives the investor a total exposure of $20,000. The investor feels the upcoming financial results will be disappointing, which could increase the pressure on the shares.
So, the investor buys put options on Company X shares via CFDs for the total shares owned. Say the investor pays a premium and commission of $1,000 for the put options. Assuming the put option strike price is $1.8, the shares eventually drop to $1.5.
If the investor doesn't buy the put option, they will lose $5,000 ($20,000-$1.5*10,000). With the put option, the investor ends up with an additional $1.8-$1.5 per share * 10,000 shares minus the $1,000 commission = $2,000. The investors' loss is reduced by $2,000 with the put option.
In the example above, the key takeaway is that options cannot 100% protect the investor from the risk. However, they can limit the risk to a known amount.
Interest Rate Differentials
In the forex world, interest rate differentials denote the variation in the interest rates between two currencies or countries. To get the interest rate differential, simply deduct the lower interest rate from the higher one.
For example, assume the current interest rate in the US is 5% and 3% in China. The interest rate differential between the two countries is 2%. By investing in the US dollars, an investor earns an extra 2% compared to investing in the Chinese Yuan.
Normally, investors use interest rate differentials to speculate on the value of currencies in the future. An increase in the interest rate makes a currency attractive since investors tend to invest in the market for higher returns. This, in turn, boosts the value of the currency.
For example, in recent times, the value of the US dollar has been pegged to the Fed's moves to tighten or loosen its policy, which includes adjusting the interest rate. Speculations of the Fed increasing rates boost the dollar and vice versa.
But how do investors hedge with interest rate differentials? Engaging in carry trades involves borrowing money from a lower-interest-rate currency and investing in a currency with high rates. Investors will then profit from the difference.
Suppose investors anticipate a sharp decline in the interest rate of a country that makes its currency less attractive. In that case, they may sell it and buy one with a higher interest rate. A significant problem is that a trade may face losses if the currency in the higher interest rate environment loses value compared to that in the lower interest rate.
Case Studies and Practical Applications
Many organizations – pension funds, mutual funds, insurance companies, oil producers, and other entities exposed to currency fluctuations hedge to protect against adverse events. We explore these below:
Successful Hedging Examples
A perfect illustration of successful hedging is by oil producers. With oil suffering from regular volatility, oil producers come together to protect themselves against potential and sudden changes in price.
They do so by buying futures contracts to protect against exposure to production. In this case, the futures contract allows the producers to sell their commodity at a set price.
For example in 2019, 60% of oil output was hedged at $60 a barrel. This protected the producers should oil prices fall below $60 a barrel. On the downside, it limits them from taking advantage of potential price increases.
Money market managers and hedge funds are another cohort that practices hedging. Wisdom Tree Trust, one of the biggest actively managed exchange-traded funds, takes different instruments to hedge against forex risks. To protect fund exposure, the company takes positions in currency forwards, futures, listed currency options, and currency swap agreements.
In 2020, Nike, a leading apparel company, was ranked the best globally for using forex options to hedge against risks. Similarly, aircraft maker Airbus was the best company using forex forwards to hedge in the same rankings.
Taiwan Semiconductor Manufacturing applies foreign currency derivatives to shield against exchange rate risks. More than 90% of the company's sales are made in US dollars and need to be translated into Taiwan's new dollars, hence the selection of the hedging technique. The company also relies on US dollar-denominated debt to protect its receivables from potential currency risks.
At the country level, governments incorporate hedging to protect against the prices of significant imports. A case in point is Uruguay, which during 2016 partnered with the World Bank to launch an oil hedging program. The hedge was conducted via a financial derivative contract, and it sought to protect Uruguay against uncertain oil price movements.
Undoubtedly, there are many examples of successful hedging in the world. This shows that hedging is a widespread technique companies use as their forex risk management strategies. But what can lead forex hedging techniques to fail?
Common Mistakes to Avoid
Implementing an effective hedging strategy could challenge many individuals and businesses. These are some of the common mistakes and how to avoid them:
Use of inappropriate hedging method
The hedging method must relate to the instrument being hedged and the conditions. Inappropriate hedging exposes an investor to over-hedging, unpleasant outcomes, or even losing protection when you need it most. Other investors may end up with hedging instruments that expose them to additional risks, such as leverage.
It is advisable that when choosing a hedging method, an investor first determines the level of risk they deem acceptable, how much they need to protect, the premiums charged, commissions, spreads, and opportunity costs. They can then choose the method that cost-effectively manages the risk.
Unclear risk management goals
What goal do you intend to achieve with the hedging strategy? Is it capital preservation, protecting against forex volatility, or smoothing exchange rates?
While the risk management goal will depend on the sector one is engaged in, it is crucial to know the intended hedging goal. It will help you set expectations correctly and determine the time horizons for your hedge.
Lack of a clear hedging policy
Many organizations keep their hedging policy open to be flexible in managing the complex and volatile forex markets. For others, maintaining a formal forex hedging policy is cumbersome and costly. Nonetheless, a lack of a clear hedging policy can lead to the following:
A loss of discipline in the hedging process exposes an organization to incorrect or inferior hedging techniques.
Disjointed hedging should an organization lose its critical competencies involved in the hedging process.
A lack of transparency and accountability in hedging and communication of its outcomes.
Not doing your homework
Unfortunately, most hedging techniques do not completely eliminate the risk in forex markets. For example, you might want to hedge using an interest rate differential by selling in a low-rate jurisdiction and investing in a high-rate market.
Although the above might seem like the right move, a sudden change of policy in the high-interest rate market that causes the rate to fall will be detrimental to the currency. A fall in the currency will potentially cause losses to the investor.
In the above example, the investors would be better off if they researched the market to understand the stability of its monetary policy. This can be said of any other hedge, as investors must understand the conditions under which they are hedging before executing.
Conclusion and Best Practices
The importance of hedging in forex cannot be underestimated, as the sector is riddled with uncertainty, volatility, and adverse exposures. Hedging protects investors from otherwise loss-inducing events and exposures in currency markets. However, to have a successful hedging outcome, investors must observe various best practices:
Being clear on what the hedging technique desires to achieve and ascertaining its cost and benefits
Choosing a hedging approach that is best for the purpose and conditions
Building and documenting a corporate forex hedging policy
Doing your homework regarding the chosen hedging technique
The list above is not exhaustive, as each hedging is unique and has its best practices. It is upon the hedger to define the risks, objectives, and conditions of the hedge to select a technique that suits them.
Disclaimer: Any information presented is for general education and informational purposes hence, not intended to be and does not constitute investment or trading or tax advice or recommendation. No opinion given in the material constitutes a recommendation by M4Markets that any particular investment, security, transaction or investment strategy is suitable for any specific person.
It does not take into account your personal circumstances or objectives. Any information relating to past performance of an investment does not necessarily guarantee future performance.
Trinota Markets (Global) Limited does not give warranty as to the accuracy and completeness of this information.
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