What Factors Affect Currency Hedging?

Mark Wollacott

Currency hedging is an attempt to reduce the risks of changes in foreign exchanges. This typically occurs when someone holds stocks in a foreign currency. In order to protect the stocks, they hold an equal amount of currency. In theory, this allows the investor to make a profit even if the currency value falls relative to the investor’s native currency.

A person making a purchase with a 20 euro bill.
A person making a purchase with a 20 euro bill.

There are two main types of currency hedging: value-adding and protection. Value-adding currency hedging looks to exact a profit from hedging, while protection merely seeks to maintain the starting value. The most common mechanism for hedging is currency swapping. Fund managers may also seek to use derivative products, stock options, insurance policies, and futures contracts.

Various types of currency.
Various types of currency.

By nature, hedge funds are dependent on currency. The fund manager will calculate the risk of a currency dive against the native currency of the investor. This means the most important factor with regards to currency hedging is currency value. If the manager miscalculates the likely fall in value or does not take the correct measures to compensate for it, the investor will make a loss on their foreign currency stocks.

The value of a currency is determined by international trade, politics, other countries, and interest rates. They are also affected by domestic consumerism, the housing market, and employment. Currencies tend to strengthen or weaken in a slow and uneven pattern; however, they are prone to sudden fluctuations caused by economic disasters, large bankruptcies, or natural disasters.

Sudden changes in currency value are relatively rare. Long term studies of currency can reveal those that are most stable. These currencies provide for better protection from risk, but are unlikely to provide sudden gains. Stable currencies tend to have stable governments and well developed economies. Currency hedging is used more often when currency values become more volatile.

Another important factor affecting currency hedging is stock value. For the currency to affect the fund solely, the stock value must remain stable. These stock values are affected by factors such as the company’s performance, profits, reputation, and rivals. The overall economic climate in the particular business sector is also an important factor for investors.

A company’s decision to use currency hedging will also be affected by its cost. The company will balance risings costs against currency volatility. If the company believes the currency is stable, it will forgo currency hedging.

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