Currency hedging is a term describing the process by which a financial instrument is used to protect an investor against the possibility that an adverse exchange rate could result in the investors’ capital losing value. Forex hedging acts in reality as an insurance policy that reduces financial risk.
For example suppose that an investor wants to buy yen because he is going to buy Japanese stocks on the Japanese stock exchange. The investor has US dollars which he is going to have to use to buy the Japanese yen. However, the investor expects to hold the stocks for a period of one year before selling them and converting the yen back into US dollars. If the investor did this without protecting himself, he would be open to currency risk.
For example if the investor sold 2 million dollars at a USD/JPY exchange rate of 98.70 he would receive 197,400,000 yen. The investor would then use these yen to buy Japanese stock. Without hedging this transaction the investor runs the risk of the yen appreciating against the dollar over the year he held the stock so when he sold the stock and then sold the yen he had received for the stock and purchased dollars, he would have received fewer dollars than he started with. Let’s assume the USD/JPY was 99.50 when the investor repurchased his dollars. He would have received only 1,983,920 dollars, some 16,000 short. Of course if the yen had depreciated over that time the investor would have made a profit. However, by not hedging this transaction, the investor stands to lose some of his capital.
What forex strategy could the investor use to reduce his risk? Well there are several ways in which the investor could have insured against his currency risk. The investor could use forex swaps, forex forwards, futures or options. As the objective of doing a hedge is to reduce currency risk instead of earning extra money on the transaction, an investor needs to invest in an additional financial product that is negatively correlated with the transaction currency pair. By doing this the investor ensures that all losses and gains offset each other and therefore minimize currency risk. It is logical that the higher the risk, the higher the opportunity but also the loss can be greater. As the hedge is reduced, the greater is the opportunity for big earnings or big losses. Conversely, as the risk is reduced, the potential for big earnings and big losses is reduced as well.
In the case of our investor who is buying yen in order to buy Japanese stocks, he could reduce his currency risk by using a forex forward instrument and sell the yen forward to coincide with when he sells his stock. That is the simplest of forex hedges available to the investor and reduces his currency risk to a known quantity.