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, a trader who is long a particular foreign currency can hedge to protect against downside risk exposure (a downward price move). On the other hand, a trader who has 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.

HEDGERS - FX RISK EXPOSURE
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.

COMMERCIAL ENTITIES
Both large and small commercial entities 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.

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.

WHY HEDGE FX 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.

Foreign Exchange Rate Risk Exposure
Foreign exchange rate risk exposure is common to most almost all conducting 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.

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 benefit from a small price discrepancy due to interest rate differentials.

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 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. Secondly, 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 repatriate the currency (exchanges the foreign currency back to domestic currency). Therefore, even if a speculative gain is achieved because the foreign stock price rose, the investor could actually 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 gain). Placing a foreign exchange hedge can help to manage this foreign exchange rate risk.

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.

FX 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.
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.

Option Contracts
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.

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.

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.

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. 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.

FX 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.

CONCLUSION
Foreign currency hedging, when properly implemented, is a valuable foreign currency risk management tool. However, foreign currency hedging if not properly implemented or supervised, 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.