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What is a Foreign Exchange Hedge?

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  • Written By: Jim B.
  • Edited By: Melissa Wiley
  • Last Modified Date: 18 September 2016
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A foreign exchange hedge is a technique by which investors protect themselves from the risk involved with trading foreign currencies. Such risks are common on the foreign exchange market, also known as the forex market, due to fluctuations in the value of foreign currencies and in foreign exchange interest rates. Typically a foreign exchange hedge occurs when an investor makes another trade to offset his forex trade or sets up his foreign exchange trade so that the exchange rates are guaranteed to be favorable. This can be done via the use of trades like options and forwards, which don't immediately take place but occur at some point in the future if they happen at all.

One of the fastest growing and heavily traded markets available to investors is the foreign exchange market, in which investors trade the currencies of different countries and attempt to benefit from price discrepancies. The forex market is also extremely volatile, meaning that foreign exchange rates can change fast. This exposes the forex investor to significant risk, and a foreign exchange hedge is one way to minimize that risk.

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There are many reasons that an investor may partake in some form of foreign exchange hedge to protect his investment. When contracts are made in advance to buy or sell goods and services from foreign countries, the price quoted in the contract may not represent the value of the currency at the time that the contract is executed. Interest rate differences between countries also may leave an investor exposed to risks. In addition, investment in foreign securities means that the investor must worry about stock prices and the foreign exchange rates.

For all of these reasons, a well-executed foreign exchange hedge is a crucial strategy for forex investors to learn if they wish to protect their investments. If done correctly, a hedge can practically eliminate the risk of a foreign exchange trade. Using some sort of underlying move to offset the exposure to the main trade can buffer the investor from any sudden moves in foreign exchange rates.

Trades set up to be executed at some point in the future are other ways in which an investor can use a foreign exchange hedge to minimize risk. Two common examples of this type of maneuver are options and forwards. An option gives the buyer the right to execute a foreign exchange trade at some specified date, but he need not make the trade if the future exchange rate is unfavorable. On the other hand, a forward trade is executed only at a specific exchange rate agreed upon by buyer and seller.

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