Foreign exchange hedging refers to techniques used to avoid foreign exchange risks. This would decrease the chance of incurring loss when trading currencies.
Hedging is usually done by companies who purchase supplies internationally. Currencies fluctuate, so companies use hedging as a means to manage currency trading risks to eliminate possible losses.
There are many foreign exchange hedging strategies.
Derivatives are agreements that allow two parties to set a particular date for trade. Currency values are unpredictable. This will allow fair trade between investors because there is an agreement between them.
Options are derivatives that allow two contracting parties to exercise a right. These rights are called options. Call options allow investors to purchase a currency at a fixed rate, while put options allow an investor to sell a currency in a specific exchange rate.
Forwards and future contracts allow two exchanging parties to set a fixed currency rate at a future time. These are both agreed upon by the two contracting parties to eliminate risks.
Foreign exchange rates are affected by many factors. These include interests, investments, economical and political changes. This means to avoid unnecessary risks, hedging has been a trend that most companies and traders practice.
Foreign exchange hedging isn’t always good for a trader. Opportunity costs are thrown away with this kind of activity. You give away the opportunity of trading at an advantage or preferably creating profits. The value of a currency fluctuates. You never know if the currency during that time would be to your advantage. As a trader, hedging secures you from further losses but prevents you from gaining higher profits.