Every kind of foreign exchange risk comes with a kind of risk. A foreign exchange hedge is one method which can be adopted by a company to decrease the foreign exchange risk involved in their transaction.

Hedge is completely based on the purchase behavior. Hedge is completely different from an arbitrage or speculation. In proper terms, hedge is a kind of derivative or financial instrument.

Hedging With Derivative

Derivative is a financial contract and the value of the derivative is based on the value of an underlying asset. The underlying asset on which the value of the derivative is determined can be an asset, commodity, equity, residential mortgage, loans, bonds, or even a commercial real estate. The underlying can also be based on climatic conditions and political situations too.

The derivative is used to decrease the risk of economic loss based on changes in the value of the underlying. This is known as hedging with derivative.

There are three types of derivatives hedging mainly:

• Forward/futures contract
• Options contract
• Swaps

A forward contract will be worked out on an exchange rate with which the transaction is likely to take place in the future.

An options contract is a kind of hedging process where the company will select the rate of exchange rates they would like to have in making exchange of currencies.

A swap contract permits exchanging the cash on the specified future rate or a bit before based on the rates of derivatives.

Hedging With Financial Instruments

Financial instruments are representations of money or money itself, proof of ownership of a property, or an agreement or contract which provides the right to pay, receive or transfer money.

Financial instruments can be:

• Cash instruments
• Derivative instruments

The value of the cash instruments is determined directly by the markets. They are readily liquefiable securities that can be transferred immediately like bank notes, bonds, debentures etcetera. Loans and deposits area also cash instruments.

It should be noted that all hedges are not financial instruments and all financial instruments are not derivatives.

Hedging Types

A gain or loss in the monetary disposition, which can be influenced by the changes in the price levels will be adjusted by changes in the value of a futures position.

• Long hedges are contracts where long position is taken on the futures contract.
• Short hedges are contracts where a short position is taken on the futures contract.
• Dynamic hedging is done based on price forecast.
• Rolling hedging is done in situations when the cash position is not known, in such cases the hedging is done with the near contract.
• Unbalanced hedging occurs when the standardized size will not match the cash position quality.

In the hedge process, the hedger attempts to fix the cost at a particular level, with the aim of ensuring assurance in the production cost or the selling cost.

It should be noted that hedge is just risk management and it is not risk elimination. By hedging the hedger transfers the risk to someone who is ready to handle the risk better or to someone who is ready to take the risk.