Forex Hedging Introduction

Forex Hedging Introduction explained by professional forex trading experts the “ForexSQ” FX trading team.

Forex Hedging Introduction

A foreign exchange hedge (also called a FOREX hedge) is a method used by companies to eliminate or “hedge” their foreign exchange risk resulting from transactions in foreign currencies (see foreign exchange derivative). This is done using either the cash flow hedge or the fair value method. The accounting rules for this are addressed by both the International Financial Reporting Standards (IFRS) and by the US Generally Accepted Accounting Principles (US GAAP) as well as other national accounting standards.

A foreign exchange hedge transfers the foreign exchange risk from the trading or investing company to a business that carries the risk, such as a bank. There is cost to the company for setting up a hedge. By setting up a hedge, the company also forgoes any profit if the movement in the exchange rate would be favourable to it.

What is Hedge

A hedge is a type of derivative, or a financial instrument, that derives its value from an underlying asset. Hedging is a way for a company to minimize or eliminate foreign exchange risk. Two common hedges are forward contracts and options.

A forward contract will lock in an exchange rate today at which the currency transaction will occur at the future date.

An option sets an exchange rate at which the company may choose to exchange currencies. If the current exchange rate is more favorable, then the company will not exercise this option.

The main difference between the hedge methods is who derives the benefit of a favourable movement in the exchange rate. With a forward contract the other party derives the benefit, while with an option the company retains the benefit by choosing not to exercise the option if the exchange rate moves in its favour.