The forex market is the largest and most liquid financial market in the world, with over 330 forex pairs available on our online trading platform. There is no shortage of foreign currencies to trade. However, the forex market is influenced by external factors such as interest rates and exchange rates, which in turn brings a level of currency risk.
Forex traders have therefore created various hedging strategies in order to minimise this currency risk. This article explores four of the most common and effective forex hedging strategies, taking into account derivative products and interest rates. Traders tend to use currency hedging instruments such as cross currency swaps, forward contracts and forex options. Hedging forex can be put to practise through the two main products on our online trading platform: spread betting and CFD trading.
What does it mean to hedge currency?
Currency hedging happens when a trader enters a contract that will protect them from interest rates, exchange rates or other unexpected changes in the forex market. Hedging forex pairs can include the major crosses, such as EUR/USD and USD/JPY, but also minor and exotic pairs. This is because the forex market can change direction in the face of political or economic events in any country. This causes each currency to either rise or decline in value.
Forex brokers offer financial derivatives to hedge against currency risk, which are typically over-the-counter products. This means that they do not trade on a centralised exchange and in some cases, derivatives can be customised at a certain point throughout the duration of the contract. However, OTC trading is not regulated and is generally seen as less safe than trading via an exchange, so we recommend that our traders have an appropriate level of knowledge before opening positions.
FX options are a form of derivatives products that give the trader the right, but not the obligation, to buy or sell a currency pair at a specified price with an expiration date at some point in the future. Forex options are mainly used as a short-term hedging strategy as they can expire at any time. The price of options comes from market prices of currency pairs, more specifically the base currency.
Let’s say that a trader decides to make a ‘call option’ and buy an amount of EUR/USD, but thinks that there may be a fall in price. He can then make a ‘put option’ and short-sell an equal amount of foreign currency at the same time in order to profit from the fall in price. This way, the trader is hedging any currency risk from the declining position and this is more likely to protect him from losses.
Another financial derivative is a forward contract. Similar to FX options, forward trading is a contractual agreement between a buyer and seller to exchange currency at a future date. Unlike a call option, the buyer has an obligation to purchase this asset and there is more flexibility for customisation. Traders can settle forward currency contracts on a cash or delivery basis at any point during the agreement, and can also change the future expiration date, the currency pair being traded and the exact volume of currency involved. Some traders prefer this method of derivative trading as it proposes slightly less risk, especially in the context of currency hedging.
Hedging with currency futures follows an almost identical process to that of forwards, apart from the fact that they are traded on an exchange.
A cross currency swap is an interest-rate derivative product. Two counterparties (often international businesses or investors) agree to exchange principal and interest payments in the form of separate currencies. They are not traded on a centralised exchange in a similar way to forwards or futures, meaning that they can be customised at any point and rarely have floating interest rates. These floating rates can fluctuate depending on the movements of the forex market.
The purpose of a cross currency swap is to hedge the risk of inflated interest rates. The two parties can agree at the start of the contract whether they would like to impose a fixed interest rate on the notional amount in order not to incur losses from market drops. The consideration of interest rates here is what separates cross currency swaps from derivative products, as FX options and forward currency contracts do not protect investors from interest rate risk. Instead, they focus more on hedging risk from foreign exchange rates.
Cross currency swap hedges are particularly useful for global corporations or institutional investors with large volumes of foreign currency to exchange.
It is a well-known fact that within the forex market, there are many correlations between forex pairs. Pairs trading is an advanced forex hedging strategy that involves opening one long position and one short position of two separate currency pairs. This second currency pair can also swap for a financial asset, such as gold or oil, as long as there is a positive correlation between them both.
Forex hedgers can use pairs trading in the short-term and long-term. As it is a market neutral strategy, this means that market fluctuations does not have an effect on your overall positions, rather, it balances positions that act as a hedge against one another. Forex correlation hedging strategies are particularly effective in markets as volatile as currency trading. Pairs trading can also help to diversify your trading portfolio, due to the multitude of financial instruments that show a positive correlation.