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We broker commodity futures, broker forex spot, broker forex options and broker OTC metals. For all of your online forex broker, online forex options broker, online OTC spot gold broker, online OTC spot silver broker and online commodity futures broker needs you only need one broker - CFOS/FX. All of the professional brokers at CFOS/FX are licensed by the National Futures Association and are qualified to provide you with the following services: forex broker, forex options broker, commodity futures broker, commodity options on futures broker, OTC spot metals broker, OTC spot metals options broker and forex and futures consulting. Commodity Futures and Options Service, Inc. is located in Houston, Texas. CFOS/FX provides both online and telephone brokerage services to retail and commercial clients. Customer satisfaction is our top priority and we look forward to having you as our client.
HOW TO HEDGE FOREX - A PRACTICAL OUTLINE
This webpage is designed to provide foreign currency hedging information to both commercial and retail foreign currency traders and foreign currency hedgers. We have provided an outline and guidelines for both commercial and retail foreign currency investors but, as each investor's hedging needs are unique, we can not possibly cover every existing foreign currency hedging scenario.
If you have any questions or would like a free consultation, please feel free to contact us.
Please click on the appropriate link below for additional forex hedging information:
I. Foreign Currency Hedging - Definition
A foreign currency hedge is placed when a trader enters the foreign currency market with the specific intent of protecting existing or anticipated physical market exposure from an adverse move in foreign currency rates. In simplest terms, an investor or trader who is long a particular foreign currency can hedge to protect against downside risk exposure (a downward price move). An investor who is short a particular foreign currency can hedge to protect against upside risk exposure (an upward price move). Both speculators and foreign currency hedgers can benefit by knowing how to properly utilize a foreign currency hedge.
II. Who Hedges Foreign Currency Risk Exposure
Both speculators and foreign currency hedgers can benefit by knowing how to properly utilize a foreign currency hedge.
A. Banks. Banks who deal internationally have inherent risk exposure to foreign currencies, often in multiple ways including trading vehicles. Placing a currency hedge can help to manage foreign exchange rate risk.
B. Commercials. Both large and small commercials who conduct international business also have risk exposure to foreign currencies. Selling in foreign currencies and accepting foreign exchange rate risk are often a function of day-to-day business and can help commercials stay competitive.
C. Retail Investors. Retail foreign currency traders use foreign currency hedging to protect open positions against adverse moves in foreign currency rates. Placing a currency hedge can help to manage foreign exchange rate risk.
III. Why Hedge Foreign Currency Risk Exposure
International commerce has rapidly increased as the internet has provided a new and more transparent marketplace for individuals and entities alike to conduct international business and trading activities. Significant changes in the international economic and political landscape have led to uncertainty regarding the direction of foreign exchange rates. This uncertainty leads to volatility and the need for an effective vehicle to hedge foreign exchange rate risk and/or interest rate changes while, at the same time, effectively ensuring a future financial position.
Each entity and/or individual that has exposure to foreign exchange rate risk will have specific foreign exchange hedging needs and this website can not possibly cover every existing foreign exchange hedging situation. Therefore, we will cover the more common reasons that a foreign exchange hedge is placed and show you how to hedge forex risk.
A. Foreign Exchange Rate Risk Exposure. Foreign exchange rate risk exposure is common to virtually all who conduct international business and/or trading. Buying and/or selling of goods or services denominated in foreign currencies can immediately expose you to foreign exchange rate risk. If a firm price is quoted ahead of time for a contract using a foreign exchange rate that is deemed appropriate at the time the quote is given, the foreign exchange rate quote may not necessarily be appropriate at the time of the actual agreement or performance of the contract. Placing a foreign exchange hedge can help to manage this foreign exchange rate risk.
B. Interest Rate Risk Exposure. Interest rate exposure refers to the interest rate differential between the two countries' currencies in a foreign exchange contract. The interest rate differential is also roughly equal to the "carry" cost paid to hedge a forward or futures contract. As a side note, arbitragers are investors that take advantage when interest rate differentials between the foreign exchange spot rate and either the forward or futures contract are either too high or too low. In simplest terms, an arbitrager may sell when the carry cost he or she can collect is at a premium to the actual carry cost of the contract sold. Conversely, an arbitrager may buy when the carry cost he or she may pay is less than the actual carry cost of the contract bought. Either way, the arbitrager is looking to profit from a small price discrepancy due to interest rate differentials.
C. Foreign Investment / Stock Exposure. Foreign investing is considered by many investors as a way to either diversify an investment portfolio or seek a larger return on investment(s) in an economy believed to be growing at a faster pace than investment(s) in the respective domestic economy. Investing in foreign stocks automatically exposes the investor to foreign exchange rate risk and speculative risk. For example, an investor buys a particular amount of foreign currency (in exchange for domestic currency) in order to purchase shares of a foreign stock. The investor is now automatically exposed to two separate risks. First, the stock price may go either up or down and the investor is exposed to the speculative stock price risk. Second, the investor is exposed to foreign exchange rate risk because the foreign exchange rate may either appreciate or depreciate from the time the investor first purchased the foreign stock and the time the investor decides to exit the position and repatriates the currency (exchanges the foreign currency back to domestic currency). Therefore, even if a speculative profit is achieved because the foreign stock price rose, the investor could actually net lose money if devaluation of the foreign currency occurred while the investor was holding the foreign stock (and the devaluation amount was greater than the speculative profit). Placing a foreign exchange hedge can help to manage this foreign exchange rate risk.
D. Hedging Speculative Positions. Foreign currency traders utilize foreign exchange hedging to protect open positions against adverse moves in foreign exchange rates, and placing a foreign exchange hedge can help to manage foreign exchange rate risk. Speculative positions can be hedged via a number of foreign exchange hedging vehicles that can be used either alone or in combination to create entirely new foreign exchange hedging strategies.
IV. Types of Foreign Currency Hedging Vehicles
Below are some of the most common types of foreign currency hedging vehicles used in today's markets as a foreign currency hedge.
* Retail forex traders typically use foreign currency options as a forex hedging vehicle. Banks and commercials are more likely to use forwards, options, swaps, swaptions and other more complex derivatives to meet their specific forex hedging needs.
A. Spot Contracts. A foreign currency contract to buy or sell at the current foreign currency rate, requiring settlement within two days.
As a foreign currency hedging vehicle, due to the short-term settlement date, spot contracts are not appropriate for many foreign currency hedging and trading strategies. Foreign currency spot contracts are more commonly used in combination with other types of foreign currency hedging vehicles when implementing a foreign currency hedging strategy.
For retail investors, in particular, the spot contract and its associated risk are often the underlying reason that a foreign currency hedge must be placed. The spot contract is more often a part of the reason to hedge foreign currency risk exposure rather than the foreign currency hedging solution.
B. Foreign Currency Options. A financial foreign currency contract giving the buyer the right, but not the obligation, to purchase or sell a specific foreign currency contract (the underlying) at a specific price (the strike price) on or before a specific date (the expiration date). The amount the foreign currency option buyer pays to the foreign currency option seller for the foreign currency option contract rights is called the option "premium."
A foreign currency option can be used as a foreign currency hedge for an open position in the foreign currency spot market. Foreign currency options can also be used in combination with other foreign currency spot and options contracts to create more complex foreign currency hedging strategies. There are many different foreign currency option strategies available to both commercial and retail investors.
If you would like detailed forex spot and option trading and hedging strategies, including strategy explanations, please click on the following link: Forex Trading and Hedging Strategies.
C. Interest Rate Options. A financial interest rate contract giving the buyer the right, but not the obligation, to purchase or sell a specific interest rate contract (the underlying) at a specific price (the strike price) on or before a specific date (the expiration date). The amount the interest rate option buyer pays to the interest rate option seller for the foreign currency option contract rights is called the option "premium." Hedging currency risk exposure with interest rate option contracts are more often used by interest rate speculators, commercials and banks rather than by retail forex traders as a foreign currency hedging vehicle.
D. Interest Rate Swaps. A financial interest rate contracts whereby the buyer and seller swap interest rate exposure over the term of the contract. The most common swap contract is the fixed-to-float swap whereby the swap buyer receives a floating rate from the swap seller, and the swap seller receives a fixed rate from the swap buyer. Other types of swap include fixed-to-fixed and float-to-float. Interest rate swaps are more often utilized by commercials to re-allocate interest rate risk exposure.
E. Currency Forwards & Swaps. Currency forwards and swaps are more often used by institutions and commercials rather than by retail forex traders.
A foreign currency forward is a contract to buy or sell a foreign currency at a fixed rate for delivery on a specified future date or period. Foreign currency forward contracts are used as a foreign currency hedge when an investor has an obligation to either make or take a foreign currency payment at some point in the future. If the date of the foreign currency payment and the last trading date of the foreign currency forwards contract are matched up, the investor has in effect "locked in" the exchange rate payment amount. * Important: Please note that forwards contracts are different than futures contracts. Foreign currency futures contracts have standard contract sizes, time periods, settlement procedures and are traded on regulated exchanges throughout the world. Foreign currency forwards contracts may have different contract sizes, time periods and settlement procedures than futures contracts. Foreign currency forwards contracts are considered over-the-counter (OTC) due to the fact that there is no centralized trading location and transactions are conducted directly between parties via telephone and online trading platforms at thousands of locations worldwide.
A currency swap is a financial foreign currency contract whereby the buyer and seller exchange equal initial principal amounts of two different currencies at the spot rate. The buyer and seller exchange fixed or floating rate interest payments in their respective swapped currencies over the term of the contract. At maturity, the principal amount is effectively re-swapped at a predetermined exchange rate so that the parties end up with their original currencies.
V. Foreign Currency Hedging Costs
When hedging forex, virtually all foreign currency hedging vehicles come at some cost. Carrying cost, option premium, margin and hedging P/L are all costs that may be associated with hedging forex. However, if you look at the foreign currency hedging cost from the proper perspective, you will most likely realize that the cost to place a forex hedge is relatively small compared to the protection forex hedging can provide. On the other hand, the whole point of placing a forex hedge is to offset forex market risk exposure at a reasonable cost - if a foreign currency hedging strategy is not cost effective then the investor should explore other options for managing forex market risk.
The cost to place a foreign currency hedge should be taken into account both before the forex hedge is placed, while the hedge is in place and again after the forex hedge is lifted. In theory, a foreign currency hedging strategy will almost always look fairly good on paper before the foreign currency hedge is placed. However, it is only after the foreign currency hedge has been placed and then lifted that the actual effect is realized. There is a learning curve involved in foreign currency hedging, and analysis and modification of the foreign currency hedging strategy are part of the learning process.
VI. Foreign Currency Broker / Dealers
Foreign currency risk management and hedging currency risk are extremely important aspects of banking, conducting international business, investing in foreign markets and retail trading of foreign currencies.
Banks and commercials will typically have specialized employees and/or professional advisors managing their foreign currency risk management group.
* Retail forex traders: Most retail forex traders do not have a risk management group and must rely on a forex hedging broker or dealer for hedging advice and to broker forex hedging transactions. To remain objective, we will refrain from making any recommendations or criticisms about other brokers/dealers. The best advice we can give is this: simply identify the types of contracts you wish to trade, find an experienced forex broker who meets your trading needs, then make sure you are comfortable with both the forex broker and the brokerage firm that you will broker forex hedging transactions through. A good forex hedging broker will not only take the time to discuss your trading objectives but will also make sure you are aware of risk management and hedging tools that will help you protect your positions and make you a better trader.
VII. How to Hedge Foreign Currency Risk
As has been stated already, the foreign currency hedging needs of banks, commercials and retail forex traders can differ greatly. Each has specific foreign currency hedging needs in order to properly manage specific risks associated with foreign currency rate risk and interest rate risk.
Regardless of the differences between their specific foreign currency hedging needs, the following outline can be utilized by virtually all individuals and entities who have foreign currency risk exposure. Before developing and implementing a foreign currency hedging strategy, we strongly suggest individuals and entities first perform a foreign currency risk management assessment to ensure that placing a foreign currency hedge is, in fact, the appropriate risk management tool that should be utilized for hedging fx risk exposure. Once a foreign currency risk management assessment has been performed and it has been determined that placing a foreign currency hedge is the appropriate action to take, you can follow the guidelines below to help show you how to hedge forex risk and develop and implement a foreign currency hedging strategy.
A. Risk Analysis. Once it has been determined that a foreign currency hedge is the proper course of action to hedge foreign currency risk exposure, one must first identify a few basic elements that are the basis for a foreign currency hedging strategy.
1. Identify Type(s) of Risk Exposure. Again, the types of foreign currency risk exposure will vary from entity to entity. The following items should be taken into consideration and analyzed for the purpose of risk exposure management: (a) both real and projected foreign currency cash flows, (b) both floating and fixed foreign interest rate receipts and payments, and (c) both real and projected hedging costs (that may already exist). The aforementioned items should be analyzed for the purpose of identifying foreign currency risk exposure that may result from one or all of the following: (a) cash inflow and outflow gaps (different amounts of foreign currencies received and/or paid out over a certain period of time), (b) interest rate exposure, and (c) foreign currency hedging and interest rate hedging cash flows.
2. Identify Risk Exposure Implications. Once the source(s) of foreign currency risk exposure have been identified, the next step is to identify and quantify the possible impact that changes in the underlying foreign currency market could have on your balance sheet. In simplest terms, identify "how much" you may be affected by your projected foreign currency risk exposure.
3. Market Outlook. Now that the source of foreign currency risk exposure and the possible implications have been identified, the individual or entity must next analyze the foreign currency market and make a determination of the projected price direction over the near and/or long-term future. Technical and/or fundamental analysis of the foreign currency markets are typically utilized to develop a market outlook for the future.
B
. Determine Appropriate Risk Levels. Appropriate risk levels can vary greatly from one investor to another. Some investors are more aggressive than others and some prefer to take a more conservative stance.1. Risk Tolerance Levels. Foreign currency risk tolerance levels depend on the investor's attitudes toward risk. The foreign currency risk tolerance level is often a combination of both the investor's attitude toward risk (aggressive or conservative) as well as the quantitative level (the actual amount) that is deemed acceptable by the investor.
2. How Much Risk Exposure to Hedge. Again, determining a hedging ratio is often determined by the investor's attitude towards risk. Each investor must decide how much forex risk exposure should be hedged and how much forex risk should be left exposed as an opportunity to profit. Foreign currency hedging is not an exact science and each investor must take all risk considerations of his business or trading activity into account when quantifying how much foreign currency risk exposure to hedge.
C. Determine Hedging Strategy. There are a number of foreign currency hedging vehicles available to investors as explained in items IV. A - E above. Keep in mind that the foreign currency hedging strategy should not only be protection against foreign currency risk exposure, but should also be a cost effective solution help you manage your foreign currency rate risk.
D. Risk Management Group Organization. Foreign currency risk management can be managed by an in-house foreign currency risk management group (if cost-effective), an in-house foreign currency risk manager or an external foreign currency risk management advisor. The management of foreign currency risk exposure will vary from entity to entity based on the size of an entity's actual foreign currency risk exposure and the amount budgeted for either a risk manager or a risk management group.
* Retail forex traders will most likely be self-reliant or will utilize the advice of a forex broker. Please see item VI. above for information on forex brokers.
E. Risk Management Group Oversight & Reporting. Proper oversight of the foreign currency risk manager or the foreign currency risk management group is essential to successful hedging. Managing the risk manager is actually an important part of an overall foreign currency risk management strategy.
Prior to implementing a foreign currency hedging strategy, the foreign currency risk manager should provide management with foreign currency hedging guidelines clearly defining the overall foreign currency hedging strategy that will be implemented including, but not limited to: the foreign currency hedging vehicle(s) to be utilized, the amount of foreign currency rate risk exposure to be hedged, all risk tolerance and/or stop loss levels, who exactly decides and/or is authorized to change foreign currency hedging strategy elements, and a strict policy regarding the oversight and reporting of the foreign currency risk manager(s).
Each entity's reporting requirements will differ, but the types of reports that should be produced periodically will be fairly similar. These periodic reports should cover the following: whether or not the foreign currency hedge placed is working, whether or not the foreign currency hedging strategy should be modified, whether or not the projected market outlook is proving accurate, whether or not the projected market outlook should be changed, any changes expected in overall foreign currency risk exposure, and mark-to-market reporting of all foreign currency hedging vehicles including interest rate exposure.
Finally, reviews/meetings between the risk management group and company management should be set periodically (at least monthly) with the possibility of emergency meetings should there be any dramatic changes to any elements of the foreign currency hedging strategy.
Foreign currency hedging, when properly implemented, is a valuable foreign currency risk management tool. However, when foreign currency hedging is not properly implemented or supervised, the result can be catastrophic.
When implementing a foreign currency hedging strategy, remember that trading and hedging foreign currency is often an imperfect science. Understand that foreign currency hedging has an inherent associated cost and that there is also a learning curve involved. If you are a retail forex trader who may need trading and/or hedging advice every now and then, make sure you have a broker who takes the time to understand your investment objectives and gives you non-biased advice.
Proper risk management is imperative is today's volatile foreign currency markets, and we hope the free hedging information above has been a help to you.
If you have any questions or would like more information about proper forex hedging, please feel free to contact us.
*Disclaimer: Foreign exchange trading, foreign exchange investments and commodity futures trading and investments are not suitable for everyone. Forex trading and commodity futures trading carry a high level of risk and the possibility exists that you could sustain a loss of all or more of your currency trading or commodity futures trading investment. Before you decide to trade foreign currency options, trade foreign currency spot markets or trade commodity futures you should be aware of all risks associated with currency trading and futures trading. If you would like more information about the risks of forex trading, commodity futures trading and of online forex trading and online futures trading, please contact a CFOS/FX futures and forex broker to discuss online foreign currency trading risks and/or commodity futures trading risks in detail.
CFOS/FX is a futures and forex broker offering online forex trading platforms in both spot forex and forex option trading markets as wells as OTC spot gold, OTC spot silver and commodity futures. The professionals at CFOS/FX broker forex spot contracts and broker forex option trading for both individual and commercial futures and forex clientele. CFOS/FX, as an entity, acts only as a futures and forex brokerage and does not actively manage futures or foreign currency trading accounts for clients. Regarding forex markets, CFOS/FX is a forex option broker and a spot forex broker acting an the Introducing Broker; CFOS/FX does not act as counter-party for client forex trading or forex option trading.