The profits that a corporation or an individual with overseas transactions makes depend in large part on the prevailing foreign exchange rates.
Because of the volatility that the forex market is known for, these companies or individuals must learn to minimize their exposure to forex trading risks to protect their profits and lessen the possible losses they may incur.
Prices can swing up or down at a moment’s notice, and whichever way the trend goes, profitability is either positively or negatively affected.
Following are some tips to mitigate forex risk:
Hedge through forwards or futures contracts. – Easily the most popular way to manage foreign exchange risks, such contracts can help protect currency holdings through hedging.
A futures contract is an agreement usually forged on a futures exchange trading floor where parties agree to buy or sell a particular financial instrument or commodity at an agreed price in the future.
On the other hand, a forwards contract is a transaction wherein the delivery is postponed pending the finalization of the contract. Although the price is pre-determined, the delivery is to be made in the future.
Hedging involves the taking of an offsetting position in a particular security. If, for example, you own a certain currency, you will sell a futures contract that sates you will be selling the said currency in the future for a set price.
When done perfectly, a hedge can minimize or reduce the risk to zero, not counting the cost incurred for the hedge.
Apply options trading as a forex risk reduction strategy. – Similar to stocks, currencies have call and put options to allow buyers to buy/sell the underlying financial instrument at a set price within a given time period or specified date. This is also known as the exercise date.
Experts consider options as the most reliable form of hedging. When used on traditional positions, forex options can greatly help minimize risks for losses in currency trades.
Use swaps. – If two companies doing business from different countries have distinct advantages on interest rates, then a swap that could benefit both parties can be arranged.
One party may enjoy lower fixed interest rates, while the other may have access to lower floating interest rates. They can swap to take advantage of the more advantageous rates.
To illustrate: Company X is based in the US and company Y is UK-based. Company X needs to avail of a British pound-denominated loan while company Y needs a US dollar-denominated loan.
The two parties may effect a swap to take advantage of the better rates that the other party enjoys in its home country. Thus, both will have savings on interest rates as they combine the benefits they enjoy in their respective country’s market.
