When Should You Consider a Currency Hedge?

One of the ways that investors limit their exposure to losses is through hedging. You can use hedging as a technique in forex trading, and you can also use a currency hedge to help you limit exposure you might have in other markets -- as well as hedge your FX market exposure. The Forex Blog offers this look at ways to hedge your indirect and direct exposure to currencies:

Hedging indirect exposure to currencies (from overseas investments) involves the separation of currency risk from credit/equity risk. In other words, if you are an American invested in a European stock, you may wish to hedge against fluctuations in the Euro (which impact you insofar as the stock is priced in and pays dividends in Euros, but your account is denominated in Dollar), so that you are exposed only to fluctuations in the stock, itself. Simply, this would involve selling Euros simultaneously with buying the stock; the amount of Euros that you sell depends on what level of exposure to currency risk you are comfortable with. If you buy $100 worth of stock in a European company and buy $100 USD/EUR, then you are fully hedged.

Hedging direct exposure to currencies is inherently more sophisticated. For example, if you sold $100 EUR/USD, you can’t hedge your position by simply buying EUR/USD, or you will negate any return without changing the level of risk. Instead, you can use financial derivatives (options, forwards, futures, swaps), which if executed properly, are tantamount to buying insurance on your portfolio. For example, if you are long the Dollar, you can buy put options in order to protect yourself from significant downside. Likewise, if you are short the Dollar, you can buy calls to achieve the same end.

With so much volatility in the financial markets right now, it is little surprise that investors and forex traders are trying to find ways to limit their exposure. Markets could go any direction, and being protected against such swings is important.