If you want to protect your business from exchange rates exposure, read this hedge topic thoroughly. After you read this article, I hope you will understand the definition of hedge and know to what extent your company can be affected by the exchange rate fluctuations. This risk management strategy is a smart way to do an investment that crucial to anticipate the risks of loss.
What is Hedge?
If we talk about hedge in the financial scope, the definition of a hedge is a hedge is an investment strategy to safeguard an investment or portfolio from loss. So, if you want to protect your finances from a risky circumstance, you can do hedging. It can be buying securities from a secondary market or doing diversification.
In other words, a hedge definition is an act of getting a position in one market to counterbalance in contrary with the potential risk by taking a position in an opposing investment or market. So, when a company performs hedging, their purpose is to limit or counterbalance your assets that are likely to lose value in the near future. It additionally confines your misfortune to a known sum in case the asset loses value.
Short-term Hedging Techniques
There are four commonly most used short-term hedging techniques which are normally be used to hedge some or all business transactions in short-term investments. Short-term hedging techniques include;
1. Futures Contract Hedging
A future contract hedging is an investment that assigns a forex in a certain volume on a given settlement date. To find out why investors use this technique, visit and read our other post about the advantages of forex trading.
2. Forward Contract Hedging
It’s a contract between a customer and a bank to make any currency buying or selling against another currency in the future at a predetermined rate at the time the contract is made. The benefits of forwarding contract hedging include;
- Avoids and minimizes exchange rate risks.
- You can do forward contract hedging according to your needs. In which, the purposes of this short-term hedging technique include:
- To cover the exchange rate risk for future currencies purchasing or selling.
- If you do a massive business transaction, the forward contract hedging may eliminate the currency exposure, because the future exchange rate has been fixed and agreed by you and the bank involved.
- Definite cost calculation.
- For speculative purposes.
3. Hedging Using Money Market Instrument
Hedging using money market instrument involves taking a position in the money market to protect future of debt or accounts position.
4. Hedging Using Currency Option
This option provides the right to buy or sell a particular currency for a specified price over a specified period of time.
Long-term Hedging Techniques
Commonly, there are 3 long-term hedging techniques that are widely used to hedge long-term exposure, which includes;
1. Long Forward
Long forward is a long-term forward contract. It’s just like the short-term forward contract, which can be designed to accommodate the specific needs of the company. Long forward is particularly attractive to companies those have been signed to long-term export or import contracts and protect their long-term cash flow.
2. Currency Swap
A Currency Swap is an opportunity to exchange one currency with another currency at a certain exchange rate and a date by using a bank as the intermediary between two parties. The objectives of currency swap include;
- Closing exchange rate risk for purchase/sale of currency
- Swap transaction will eliminate currency exposure because exchange rate exchange in the future has been determined.
- Exact cost calculation
- For the purpose of speculation
- Gapping strategy
- Currency Swap advantages:
- Avoids the risk of currency exchange
- Doesn’t disturb the items in the balance sheet
3. Parallel Loan
Parallel Loan is a credit that involves a currency exchange between two parties, with an agreement to redeem those currencies at a certain future rate and date. Parallel Loan can be identified with two swaps combined into one. By which, one swap is taking place at the beginning of the parallel loan contract and the other swap on a certain date in the future.
Hedging Through Derivatives
Investors may employ many hedge fund managers to offset their investments, which are normally exclusive speculation funds. The government doesn’t control them as to the tune of mutual funds whose proprietors are open enterprises.
Hedge funds commonly wage their executants 1% of the profits they gain. They don’t get anything in case their investments incur losses. That draws in numerous financial specialists who are baffled by shelling out mutual fund fees paying little respect to its outcome.
On account of this remuneration composition, hedge fund executants are headed to accomplish above-market returns. Executants who make awful speculations may lose their jobs. They preserve the fees they’ve set aside amid the great circumstances. In the event that they bet substantial, and accurately, they get profit. But when they lose, they don’t forfeit with their own cash. This causes them extremely hazard tolerant. It additionally causes the funds dubious for the financier.
Hedge funds that employ subordinates have ever added financial crisis worldwide. Setting the phase for the economic emergency of 2008.