Understanding the Benefits of Hedging

A common term heard in foreign exchange market is currency hedging, which, by its basic definition, refers to a way of safeguarding a trader’s position from negative shifts in the exchange rates. Although at times this strategy may be seen as uncertain since it may result to a denomination being left behind in case of an increase in a currency’s value against the dollar. However, in this field, it is as important to take into account your potential risks as well as your gains.

For example, a particular UK company is based in the US. Whenever it provides capital to its branches, the money is converted into the other nation’s currency, including the stores’ profits. The initial rate of swap is at $1 for every £2. Now assume that this has changed suddenly into $1 for £4. With this given, the British pound sterling becomes less valuable. This is where hedging, which is applicable in mutual funds and ETFs as well, enters the picture.

Primarily, it fends off long term risks, considering that rates may fluctuate due to either political or economic factors. Aside from this, hedging contributes to the diversity of your portfolio. To put it simply, if startups are attractive to investors who are willing to take high risks to obtain greater returns, they can lessen their vulnerability to uncertainties especially since most of them use overseas-based investments.

Also, many funds hedge using the concept of forward contracts. This enables you to freeze your payment for a denomination so as to maintain them until a specific period of time to avoid an impact in case the value depreciates. However, it is necessary to know that this only applicable when a currency weakens relative to the greenback. During situations when your cash becomes more valuable, this contract is not required anymore.

Still, the main purpose of hedging is to cushion the investor if a denomination’s value falls to a great extent. Despite the method not seeming like a wise idea because it causes other portfolios to advance ahead, in an event of decline, this will be more of an advantage to you, since it will soften the blow brought by the downturn.