What do we mean when say hedging in forex?
Hedging is trying to avoid or prevent anything or any event that may cause losses in the forex market. However, even though our main topic today is hedging in forex, hedging does not apply to forex alone. It is also applicable to all financial markets.
If we are talking about size and massiveness, we can say that forex is considered the biggest and most liquid among all financial markets in the world. There is zero to minimal chance to run out of currencies to trade. As a result, people started to figure out ways to evade currency risks that depend on economic factors. One of these ways is hedging.
Forex brokers or market makers offer over-the-counter financial instruments that we call currency pairs that people can trade to gain profit. It means that the forex market is not centralized, and traders can customize how they want their order to turn out. With that being said, many people may have doubts about OTC trading because it does not seem too safe as there are lesser regulations.
Tell me more about hedging in forex.
There is a term called currency hedging, where a trader agrees on a contract that avoids or even removes the risks of interest and exchange rates and market fluctuations. Hedging is applicable in almost all currency pairs. It applies to major currency pairs like EUR/ USD, minor currency pairs that are not included in the six major currency pairs, and the exotic currency pairs. Economic events can have a massive impact on the forex market. Traders will do their best to avoid this scenario by hedging and being knowledgeable and alert about events.
Hedging risks in the forex market is not an easy task, especially for beginners. But there is always room for learning and improvement if someone is determined enough.
An example scenario
For citing an example, we will only assume the figures and are not the actual and current value today. Let us assume that one Euro is equivalent to one US dollar. A European company is planning to sell high-quality furniture sets in America. The cost of making one furniture set, including the labor, is €1,000. They would sell these sets at €1,100 each. If their sales go well, they will have €100 profit per set since $1 is equal to €1. However, because there are price fluctuations and constant change, the Euro’s value increased more than the US Dollar.
Now, €1 is equal to $0.90. Even though Euro is now much stronger than the US Dollar, it still costs $1,000 to make one furniture set, and they still need to sell them at $1,1000. In this case, the American country has lesser profits to take home due to the change.
We can avoid these cases by selling USD and buying Euros when their values are equal. There is always a significant risk when countries do business in foreign countries because of the different currencies and the changes. Forex markets can help in hedging currency risk when they fix rates after the transaction completes. These companies can trade in forward or swap markets ahead of time to lock in the exchange rates.